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Principles   of  Accounting 


BY 

JOHN  RAYMOND  WILDMAN,  B.Sc.  M.C.S..  C.P.A. 

of  the  Firm  of  Haskins  and  Sells  and  Professor  of  Accounting  in  New  York  University 
School  of  Commerce,  Accounts  and  Finance 


1922 

NEW  YORK  UNIVERSITY  BOOK  STORE 
32  WAVERLY  PLACE,  NEW  YORK 


Copyright,  1922 

BY 

JOHN  RAYMOND  WILDMAN 


FOREWORD 

Changes  in  the  tax  law  have  rendered  obsolete  certain  chap- 
ters and  references  which  appeared  in  the  author's  Principles 
of  Accounting  as  originally  published.  A  revision  of  the  book 
thus  being  indicated,  advantage  has  been  taken  of  the  oppor- 
tunity to  make  certain  other  changes  in  the  text  which  experience 
indicates  as  being  desirable.  These  have  resulted  in  the  elimina- 
tion of  the  earlier  chapters  dealing  with  the  economic  aspect  of 
accounting,  and  in  a  different  treatment  of  reserves. 

The  author  acknowledges  frankly  that  further  investigation 
of  the  subject  of  reserves  has  developed  a  better  appreciation  of 
the  differentiation  among  them,  and  such  conclusion  makes  neces- 
sary treatment  different  from  that  formerly  accorded  to  them. 

There  has  been  added  in  the  revised  text  certain  material 
dealing  with  the  interpretation  of  financial  statements  which, 
while  meagre  in  its  scope  and  somewhat  general  in  discussion, 
tends  to  round  out  the  book,  and  an  appendix  dealing  with  the 
subject  of  capital  stock  without  par  value. 

Acknowledgment  is  gratefully  made  to  Mr.  E.  Alfred  Davies, 
wherever  he  may  be,  last  heard  from  as  a  sergeant  in  the  Canadian 
army  assigned  to  duty  in  Russia,  who,  when  a  student  at  New 
York  University,  gave  evidence  of  having  read  the  original  text 
carefully  by  offering  the  author  a  list  of  typographical  errors. 
Needless  to  add,  these  have  been  corrected  in  the  present  edition. 

John  Raymond  Wildman. 
New  York,  June  15,  1922. 


PREFACE 

In  presenting  this  book,  the  author  desires  to  have  understood 
that  it  is  not  a  treatise  on  accountancy.  It  deals,  as  the  title 
states,  with  the  principles  of  accounting. 

Accounting  may  be  defined  as  that  science  which  treats  of 
the  systematic  compilation  and  presentation  in  a  comprehensive 
manner,  for  administrative  purposes,  of  the  facts  concerning  the 
financial  operations  of  a  business  organization. 

Accountancy  is  most  aptly  defined  in  the  Certified  Public 
Accountant  Syllabus  issued  by  the  New  York  Education  Depart- 
ment as,  "a  profession,  the  members  of  which,  by  virtue  of  their 
general  education  and  professional  training,  offer  to  the  commu- 
nity their  services  in  all  matters  having  to  do  with  the  recording, 
verification  and  presentation  of  facts  involving  the  acquisition, 
production,  conservation  and  transfer  of  values." 

Bookkeeping  has  been  defined  as,  "the  art  of  recording  pecu- 
niary transactions  in  a  regular  and  systematic  manner." 

From  the  above  definitions  it  will  be  seen  that  there  are 
marked  differences  between  bookkeeping  and  accounting,  and 
accounting  and  accountancy.  The  requirements  of  a  knowledge 
of  bookkeeping  are  overshadowed  by  those  of  accounting.  Ac- 
countancy is,  in  turn,  much  broader  in  its  scope  than  the  latter. 

With  the  ever-present  recollection  that  the  subject  of  this  dis- 
cussion is  accounting  as  a  science  and  not  professional  accounting, 
the  book  should  be  read. 

It  has  been  prepared  as  a  text,  constituting  the  foundation, 
or  framework  of  the  course  in  Theory  of  Accounting,  as  given 
in  New  York  University  School  of  Commerce,  Accounts  and 
Finance.  As  such  it  is  supplemented  by  extensive  collateral  read- 
ing, with  a  view  of  bringing  to  the  attention  of  the  student  the 
greater  detail  on  many  topics,  which  obviously  is  impossible  in 
a  work  of  this  character,  as  well  as  the  views  of  other  writers 
on  this  and  allied  subjects. 

The  subject  has  herein  been  approached  in  a  manner  different 
from  most  books  on  accounting.     The  choice  of  most  writers 


Preface 

seems  to  be  the  analytical  method,  beginning  with  the  financial 
statements  as  a  basis.  The  present  work  makes  use  rather  of 
the  synthetical  method,  with  the  preparation  of  financial  state- 
ments  for  administrative  purposes  as  the  objective.  An  attempt 
has  been  made  to  tie  in  the  allied  subjects,  such  as  economics, 
law,  finance  and  organization,  and  to  show  the  relation  which 
accounting  bears  to  these  subjects. 

The  author  desires  to  record  his  appreciation  of  the  assist- 
ance rendered  by  his  friends  and  associates,  William  Wallace 
Douglas  and  John  Thomas  Madden,  of  the  accounting  faculty 
of  New  York  University  School  of  Commerce,  Accounts  and 
Finance.  Both  have  been  patient  with  his  shortcomings  and 
especially  helpful  with  suggestions  and  constructive  criticism. 

The  author  also  desires  to  present  the  book  as  a  modest  and 
conscientious  attempt  on  his  part  to  gather  together  for  students 
the  principles  of  accounting  rather  than  a  masterpiece  born  of 
egotism. 

John  Raymond  Wildman. 

New  York,  May  22,  1913. 


CONTENTS 


CHAPTER  PAGE 

I    The  Object  Which  Accounting  Seeks  to  Accomplish i 

II     Accounts:  Classification 6 

III  Assets  and  Liabilities  Classified 9 

IV  Nominal  Accounts  Classified 14 

V     Special  Functions  of  Certain  Accounts 20 

VI    The  Property  Accounts 23 

VII     Buildings 27 

VIII     Buildings  (continued) 45 

IX     Buildings — ^What  May  Happen  to  Them 49 

X     Equipment , 58 

XI     Investments 65 

XII     Working  and  Trading  Assets 74 

XIII     Current  Assets 82 

XIV     Patents,  Copyrights  and  Trademarks 90 

XV     Franchises 95 

XVI     Goodwill 98 

XVII    Funds 103 

XVIII     Deferred  Charges  to  Expense 109 

XIX     Consignments 115 

XX     Capital  Liabilities 125 

XXI     Reserves 130 

XXII     The  Relation  of  Funds  to  Reserves 140 

XXIII     Proprietorship 149 

XXIV    The  Income-from-Sales  Group 155 

XXV    The  Cost-of-Sales  Group 159 

XXVI     Gross  Profit  on  Sales  and  Turnover 165 

XXVII     The  Selling-Expense  Group 172 

XXVIII     The  Administrative-Expense  Group 176 

XXIX    The  Secondary-Income  Group 181 

XXX    Deductions  from  Income  Group 187 

XXXI     Depreciation 192 

XXXII     Interest 207 

XXXIII  Insurance 217 

XXXIV  Taxes 226 


Contents 


CHAPTER  PAGE 

XXXV    Miscellaneous  Profits  and  Losses 232 

XXXVI     Accruals  and  Closing  Entries 236 

XXXVII     The  Preparation  of  Financial  Statements 241 

XXXVIII    Financial  Statements  as  Aids  to  Administration 274 

Appendix    Capital  Stock  Without  Par  Value 288 

INDEX 306 


Principles  of  Accounting 

By  John  R.  Wildman 


CHAPTER  I 


THE  OBJECT  WHICH  ACCOUNTING  SEEKS  TO  ACCOMPLISH 

The  object  of  accounting  is  to  ascertain,  compile,  and  present 
in  a  comprehensive  manner,  for  administrative  purposes  all  the 
facts  concerning  financial  operations  and  conditions. 

Business  men  are  coming  to  realize  that  proper  and  adequate 
financial  statements  are  a  highly  important,  if  not  an  indispen- 
sable aid,  to  successful  administration. 

It  is  not  so  long  since  many  concerns  used  merely  a  single 
entry  system  of  keeping  their  books  and  depended,  so  to  speak, 
upon  an  inventory  of  assets  and  liabilities  at  the  end  of  the  year 
in  order  to  determine  their  financial  condition.  From  such  an 
inventory  there  was  compiled  a  list  of  accounts  separated  as  to 
assets  and  liabilities  which  was  called  a  balance  sheet  and  which 
showed  the  surplus  or  deficit.  The  profit  or  loss  was  determined 
by  a  comparison  of  the  surplus  or  deficit  at  the  end  of  the  period 
with  that  at  the  beginning.  All  that  could  be  established  was  the 
fact  that  a  gain  had  been  made  or  a  loss  sustained  and  the  extent 
in  either  case.     Such  information  was  obviously  very  meagre. 

The  question,  presumably,  which  began  to  arise  in  the  minds 
of  proprietors  in  case  of  a  gain  was,  "What  was  the  cause  or 
causes  from  which  the  profits  have  resulted?"  With  the  aid  of 
double  entry  bookkeeping  and  the  accompanying  nominal  ac- 
counts a  profit  and  loss  account  became  possible.  This  summary, 
which  was  a  transcript  of  the  corresponding  accounts  in  the 
books,  was  crude  at  first,  and  while  nothing  more  than  a  classified 
list  of  debits  and  credits,  did  explain  in  a  measure  the  increase  or 
decrease  in  the  surplus  or  the  deficit. 

To  the  inquisitive  proprietor,  even  of  a  small  concern,  such 
a  statement  probably  proved  unsatisfactory.  The  account  might 
have  been  called  a  hodgepodge  of  information  accounting  arith- 
metically for,  and  to  a  certain  extent  explaining  in  general  terms 
the  causes  of,  profits  and  lossses,  but  the  business  man  began  to 
ask  for  something  more  definite ;  something  more  concrete ;  some- 

I 


Principles  of  Accounting 

thing  which  would  tell  him  with  more  precision  just  why  a  profit 
had  been  made.  He  was  also  dissatisfied  at  having  to  wait  until 
the  end  of  a  year  before  obtaining  this  information. 

Quite  naturally  he  began  to  ask,  if  he  happened  to  be  engaged 
in  manufacturing,  "How  much  do  I  make  on  my  goods  without 
taking  into  consideration  the  expenses  of  selling  them,  or  the 
expense  of  conducting  the  business  ?"  To  satisfy  this  want  on  the 
part  of  the  proprietor,  the  accountant  presumably  prepared  a 
more  elaborate  statement  of  the  profit  and  loss  for  the  period, 
which  divided  the  total  expense  of  conducting  the  business  into 
three  classes;  namely,  manufacturing,  selling,  administrative  and 
general.  He  arranged  to  show  the  profit  after  each  class  of 
expense  had  been  deducted.  His  statement  was  in  account  form 
and  was  known  as  the  trading  and  profit  and  loss  account,  or  as 
the  manufacturing,  trading  and  profit  and  loss  account.  This 
latter  statement  probably  attained  greater  popularity  than  the 
former.  It  was  divided  into  three  sections,  entitled  respectively, 
manufacturing,  trading,  and  profit  and  loss.  The  first  section  had 
as  its  object  the  gathering  together  of  all  the  items  of  cost  or 
expense  affecting  the  manufactured  goods  sold.  These,  of  course, 
comprised  the  stock  at  the  beginning  of  the  year,  whether  in  the 
shape  of  raw  material,  goods  in  process,  or  finished  goods,  to 
which  was  applied  the  respective  inventories  at  the  end  of  the 
period.  It  also  included  wages,  rent  and  taxes  of  factory,  depre- 
ciation on  machinery  and  all  incidental  items  of  expense  effecting 
the  manufacturing.  When  this  cost  of  manufactured  goods  sold 
had  been  ascertained,  the  section  was  closed  out  by  being  bal- 
anced and  the  balance  was  brought  down  to  the  second  section, 
or  that  called  trading.  This  section  showed  on  the  credit  side  the 
sales,  and  on  the  debit  side  the  cost  of  sales  plus  salesmen's  sal- 
aries and  expenses,  together  with  discounts  on  sales.  It  was 
balanced  in  a  manner  similar  to  the  first  section,  and  the  balance 
carried  down  to  the  profit  and  loss  group.  In  this  section  the 
gross  profit  on  trading  appeared  on  the  credit  side  and  was  offset 
by  such  items  as  the  rent  of  warehouse,  salaries  of  clerks,  depre- 
ciation on  factory,  office  expenses,  reserve  for  bad  debts,  interest, 
dividends,  etc. 

This  statement,  while  quite  obviously  an  improvement  over 
the  original  profit  and  loss  account,  still  left  something  to  be  de- 
sired.    While  intended  to  allocate  profits  to  a  certain  extent,  it 

2 


Object  which  Accounting  Seeks  to  Accomplish 

possessed  to  such  a  degree  the  features  of  a  ledger  account,  that 
it  was  generally  condemned  by  the  proprietor,  who  as  a  rule 
understood  little  about  bookkeeping,  as  being  too  intricate  for 
his  interpretation.  It  worked  its  way  into  favor  with  bookkeepers 
in  this  country  at  a  time  when  very  little  attention  had  been  given 
by  them  to  financial  statements.  It  is  supposed  to  have  come  from 
England,  where  it  originated.  It  has  now  been  largely  discarded 
in  favor  of  a  statement  which  is  known  as  the  statement  of  income 
and  profit  and  loss. 

This  statement  presumably  came  in  response  to  the  persistent 
demands  on  the  part  of  the  proprietor  for  financial  statements 
which  would  be  of  use  to  him  in  running  his  business,  so  to  speak. 
Many  such  men  have  been  heard  to  say,  "What  I  want  is  a 
statement  which  I  can  understand  and  which  will  help  me  to 
run  my  business  and  make  more  money."  "What  I  want  is  an 
income  statement  which  will  tell  me  whether  I  am  making  money 
through  proper  and  consistent  manufacturing  cost,  or  whether  I 
am  losing  money  because  my  selling  or  administrative  expense 
or  my  fixed  charges  or  any  one  of  them  is  too  high.  If  I  lose 
money,  I  want  to  know  whether  my  selling  price  is  too  low  or  my 
cost  and  expense  items  too  high,  and  above  all,  I  want  a  statement 
which  I  can  understand.  I  know  nothing  of  bookkeeping  or 
accounting,  and  I  do  not  wish  to  be  bothered  with  highly  technical 
and  involved  statements." 

The  statement  of  income  and  profit  and  loss  is  the  latest  de- 
vice for  supplying  the  wants  of  the  business  man  with  informa- 
tion as  to  his  operations.  While  it  has  developed  into  a  somewhat 
elaborate  statement,  it  is  so  arranged  as  to  present  to  the  business 
man  in  a  simple  and  logical  manner  that  which  he  desires.  It 
does  away  with  all  bookkeeping  features ;  there  is  no  such  thing 
as  debts  and  credits.  It  deducts  one  item  from  another  in  the 
same  way  that  the  layman  would  do  it,  "if  he  were  figuring  up  his 
profits."  It  seems  to  appeal  to  him  and  be  possible  of  interpre- 
tation by  him  for  this  reason.  It  is  constructed  in  accordance 
with  the  divisions  of  organization.  It  sets  out  clearly  the  cost 
incident  to  manufacturing,  selling  and  administration.  It  sep- 
arates from  these  departments,  which  comprise  the  operations, 
all  such  items  as  secondary  income  or  deductions  therefrom.  It 
complies  with  the  economic  theories  with  regard  to  interest,  rent, 
taxes,  etc.     It  allocates  the  profits  to  the  respective  division  of 

3 


Principles  of  Accounting 

organization  showing  gross  profit,  selling  profit  and  net  profit. 
It  shows  the  income  from  operations  and  the  income  from  sources 
other  than  operations.  It  gives  the  business  man  a  statement 
from  which  to  form  his  judgments  and  to  administer. 

The  balance  sheet  of  to-day  has  also  undergone  some  remark- 
able changes.  From  an  intricate  mixture  of  accounts,  classified 
only  as  to  debit  and  credit,  it  has  become  a  statement  of  great 
refinement,  showing  not  only  the  true  financial  condition  but 
carrying  with  it  information  which  is  of  inestimable  value  to  the 
proprietor  or  administrative  officer.  It  now  enables  him  to  deter- 
mine the  manner  in  which  his  capital  is  invested;  the  extent  to 
which  his  equity  in  the  organization  exists ;  to  separate  his  fixed 
capital  from  his  working  capital ;  to  determine  which  assets  have 
an  intrinsic  value  and  those  which  are  carried  merely  as  a  matter 
of  courtesy  for  accounting  purposes. 

The  fact  that  scientifically  prepared  financial  statements  are 
desirable  and,  in  fact,  needed  by  the  business  man  who  hopes  to 
become  successful  would  appear  to  pass  unchallenged.  That 
great  corporations  are  in  effect  magnified  individuals,  the  power 
of  observation  of  whose  officers  is  limited,  will  also  probably  be 
unquestioned.  That  such  officers  must  have  some  artificial  means 
of  transcending  such  limits  is  also  quite  evident.  Financial  state- 
ments, with  their  accompanying  statistical  data,  furnish  such  a 
means. 

The  duty  which  confronts  the  accountant  is  that  of  presenting 
such  financial  statements  and  presenting  them  when  needed. 
Some  concerns  require  statements  showing  daily  profits,  others 
what  might  be  termed  perpetual  balance  sheets,  while  the  great 
majority  probably  close  their  books  either  semi-annually,  quar- 
terly or  monthly.  These  statements  will  not  prepare  themselves. 
They  will  not  permit  of  successful  preparation  unless  some 
arrangement  has  been  made  to  secure  the  facts  and  figures  essen- 
tial to  their  preparation.  In  order  that  this  may  be  accomplished 
it  is  necessary  that  the  accountant  should  thoroughly  understand 
books,  the  object  in  keeping  them,  their  classification,  their  form 
and  ruling;  methods  of  bookkeeping;  of  accounts,  their  philoso- 
phy, classification,  and  arrangement  in  books ;  the  relation  which 
each  account  bears  to  allied  subjects,  such  as  economics,  law  and 
finance ;  the  peculiar  effect  which  the  various  economic  and  legal 

4 


Object  which  Accounting  Seeks  to  Accomplish 

types  of  organization  and  various  lines  of  business  have  upon  the 
accounts  and  the  accounting  technique. 

The  accountant  having  in  mind  the  results  which  he  wishes 
to  attain,  plans  his  work  accordingly.    He  begins  with  the  selec- 
tion of  proper  books.     He  proceeds  by  choosing  such  accounts 
as  will,  when  properly  arranged,  reveal,  in  accordance  with  eco- 
nomic principles,  a  complete  record  of  the  financial  transactions 
of  the  particular  type  of  organization  involved  and  facilitate  the 
preparation  of  comprehensive  financial  statements.     Not  alone 
arithmetical   statements   which  are  mathematically  correct  and 
accurate   with   regard   to   the   facts,   but  statements   which   set 
forth  such  facts  in  a  manner  which  can  be  readily  understood. 
A  balance  sheet  may  set  forth  all  the  real  accounts.     It  may 
show  the  financial  condition  of  the  organization.     An  income 
statement  may  disclose  all  the  nominal  accounts  and  show  the 
results  of  operation  during  the  period  just  past.    If  the  arrange- 
ment is  disregarded,  the  statements  will  have  little  meaning. 
Properly  arranged,  they  may  be  of  immense  value  to  the  pro- 
prietor or  administrative  officer.     They  may  show  not  only  the 
financial  condition  and  the  results  of  operation  in  the  past,  but 
light  the  way  to  improvement  in  the  future.     A  properly  con- 
structed balance  sheet  may  be  a  most  important  factor  in  guid- 
ing the  financial  policies.    A  statement  of  income  and  profit  and 
loss,  wherein  items  of  cost  are  grouped  around  units  of  pro- 
duction and  items  of  expense  around  units  of  service,  may  be 
most  helpful  as  an  index  to  efficiency  and  honesty  or  as  a  warn- 
ing of  weakness  or  impending  danger.    To  discuss  the  elements 
necessary  to  the  preparation  of  comprehensive  financial  state- 
ments will  be  the  purpose  of  the  following  chapters. 

REFERENCE  FOR  COLLATERAL  READING: 

Business  Education  and  Accountancy,  Haskins,  Chapters  I, 
II,  V,  VI. 


CHAPTER   II 

ACCOUNTS  :   CLASSIFICATION 

The  kinds  of  accounts  to  be  kept  depend  upon  the  informa- 
tion desired.  The  primary  demand  is  for  information  concern- 
ing the  financial  condition.  The  secondary  demand  is  for  in- 
formation as  to  how  the  financial  condition  was  brought  about. 

Financial  condition  is  shown  by  gathering  together  all  values 
of  a  positive  character  and  opposing  against  them  all  values  of 
a  negative  character.  The  difference  resulting  is  expressed  in 
an  account  called  "  capital "  or  "  proprietorship." 

Financial  condition  is  constantly  changing.  Scarcely  a  sale 
of  goods  takes  place  which  does  not  effect  such  a  change.  It 
usually  consists  in  substituting  in  place  of  goods  on  hand  for 
sale,  carried  at  cost,  an  account  due  from  a  customer,  the  amount 
of  which  includes  in  addition  to  the  cost  of  the  goods  sold,  an 
item  of  profit.  Any  change  in  the  values  reflecting  financial 
condition  changes  the  capital.  A  comparison  of  capital  at  two 
dates  determines  the  extent  of  its  growth  or  shrinkage  during  the 
period  intervening.  It  shows  the  effect  of  having  engaged  in  a 
financial  undertaking.  It  does  not  show  the  cause  of  the  change 
in  capital.  Whether  the  effect  be  pleasing  or  otherwise,  curiosity 
might  be  assigned  as  a  reason  for  demanding  information  con- 
cerning the  cause  of  the  change.  As  a  matter  of  fact  the  reason 
is  a  far  more  logical  one.  Men  have  found  that  by  getting 
information  as  to  what  has  happened  in  the  past  they  are  in  a 
better  position  to  direct  the  affairs  of  the  future. 

In  order  to  be  able  to  express  the  financial  condition  at  the 
proper  time,  it  is  only  necessary  to  have  accounts,  the  titles  of 
which  will  describe  individually  the  various  values  which  reflect 
financial  condition. 

To  trace  the  steps  in  the  ever-changing  financial  condition  is 
a  more  difficult  matter.  Every  change  alters  the  proprietor's  or 
capital  account.  Such  changes  may  be  due  to  one  or  more  of 
several  causes ;  the  result  of  operating,  or  the  active  employment 
of  the  capital ;  fluctuations  in  values  due  to  economic  conditions ; 
a  decrease  in  certain  material  values  owing  to  lapse  of  time.  To 
record  every  change  in  the  proprietor's  account  would  be  an 
arduous  task.     In  order  that  this  may  be  avoided  it  has  been 


Accounts:  Classification 

found  desirable,  to  substitute  and  use  in  place  of  the  capital 
account,  during  the  time  which  the  account  period  covers,  a 
series  of  accounts  which  will  record,  in  a  classified  manner,  the 
changes  taking  place  in  the  capital  account.  When  they  have 
done  this,  they  have  served  their  purpose  and  they  are  closed, 
at  the  end  of  the  accounting  period,  into  a  summary,  the  net 
result  shown  therein  being  subsequently  closed  into  the  proprie- 
tor's account. 

Having  in  mind  the  above  remarks  it  may  be  said  that  ac- 
counts divide  into  two  great  kinds,  or  classes,  namely, 

real,  and 
nominal 
definitions  for  which  may  now  be  constructed  without  any  par- 
ticular difficulty. 

Real  accounts  are  those  which  reflect  financial  condition. 

Nominal  accounts  are  those  which  reflect  changes  in  financial 
condition. 

It  is  not  to  be  thought  strange  if  the  mind  of  the  attentive 
student  seeks  information  as  to  the  reason  for  selecting  the 
words  real  and  nominal  to  describe  two  classes  of  accounts  of 
such  importance.  Authority  for  the  use  of  the  words  is  difficult 
to  find  but  it  is  probable  that  they  were  selected  because  of  the 
fact  that  accounts  showing  the  financial  condition  represent 
values  which  really  and  definitely  exist,  whereas  those  accounts 
which  record  the  changes  merely  mark  the  course  of  the  changes. 
The  latter  are  accounts  which  exist  in  name  only  so  far  as  rep- 
resenting anything  concrete  is  concerned. 

Whether  real  accounts  show  the  financial  relations  of  the  pro- 
prietor with  persons  as  distinguished  from  things  would  seem 
to  be  of  little  importance ;  however,  in  passing  it  is  to  be  noted 
that  some  authors  do  take  considerable  cognizance  of  a  classifi- 
cation which  divides  accounts  into  personal  and  impersonal.  If 
definitions  of  these  terms  were  required  it  might  be  said,  al- 
though with  some  absurdity,  that  a  personal  account  is  a  real 
account  purporting  to  reflect  the  financial  relation  existing  be- 
tween the  proprietor  and  some  person,  whereas  an  impersonal  ac- 
count purports  to  reflect  the  financial  relation  existing  between 
the  proprietor  and  some  thing. 

Attention  should  be  directed  to  the  fact  that  nominal  accounts 
are  frequently  known  by  other  names.     They  are  sometimes  re- 


Principles  of  Accounting 

ferred  to  as,  economic  accounts,  income  and  expense  accounts^ 
revenue  and  expense  accounts,  profit  and  loss  accounts,  income 
and  outgo,  etc. 

Real  accounts  divide  into  two  classes :  those  which  represent 
positive  values  and  those  which  represent  negative  values.  The 
accounts  in  the  former  class  are  called  assets;  in  the  latter,  lia- 
bilities. An  asset  is  a  possession  of  positive  value.  An  asset 
account  may  be  defined  as  one  which  represents  an  asset.  An 
asset  may  be  tangible  or  intangible.  Some  assets  are  in  the  form 
of  property  or  funds.  They  are  said  to  be  tangible  assets.  Other 
assets  exist  in  the  form  of  rights  against  persons,  which  persons 
may  be  either  real  or  artificial.  Such  assets  are  said  to  be  in- 
tangible. Assets  may  also  take  the  form  of  deferred  charges  to 
income.  They  are,  in  truth,  expenses,  but  in  view  of  the  fact 
that  the  accounting  period  to  which  they  are  applicable  has  not 
yet  arrived,  they  are  considered  as  in  the  light  of  having  value, 
which  value  is  positive  in  its  nature  and  they  are  consequently 
entitled  to  inclusion  among  the  assets. 

A  liability  denotes  negative  value.  It  is  an  offset  to  values 
possessed.  It  is  something  which  must  ordinarily  be  made  good 
out  of  the  assets.  Further  than  that,  it  is  something  which  the 
proprietor  of  a  business,  if  the  assets  of  the  business  are  in- 
sufficient, must  settle  out  of  private  funds.  It  is  something 
which  gives  a  right  of  action  at  law  in  favor  of  the  creditor  as 
against  the  proprietor.  A  liability  may  be  defined  as  an  indebted- 
ness giving  to  the  creditor  a  right  of  action  at  law  against  the 
debtor.  A  liability  account  may  be  defined  as  one  which  sets 
forth  a  liability. 

A  liability  should  be  distinguished  from  an  accountability  in 
that  an  account  must  be  stated  and  the  amount  definitely  ascer- 
tained before  a  liability  arises.  Accountability  is  perhaps  best 
illustrated  by  showing  its  application  in  agency.  An  agent  is  the 
representative  of  his  principal.  He  may  have  received  from  the 
principal  certain  values  for  which  he  must  account.  He  may  be- 
come liable  to  his  principal,  ultimately,  but  technically  he  is  not 
liable  until  such  time  as  he  has  accounted  to  his  principal  for  the 
values  received  and  the  disposition  made  of  same.  An  account- 
ability may  be  defined  as  that  condition  existing,  where  in  the 
relation  between  two  parties,  or  entities,  one  must  account  to  the 
other  for  values  received. 

REFERENCE  FOR  COLLATERAL  READING: 

Philosophy  of  Accounts,  Sprague,  Chapters  IV,  VII. 

8 


CHAPTER   III 

ASSETS  AND  LIABILITIES  CLASSIFIED 

Assets  may  be  divided  into  five  general  groups,  namely,  fixed 
or  capital  assets,  working  and  trading  assets,  current  assets, 
miscellaneous  or  special  assets  and  deferred  charges  to    expense. 

Fixed  or  capital  assets  are  those  which  represent  that  portion 
of  the  capital  of  the  organization  invested  in  assets  which  are 
more  stable  in  their  nature ;  those  which  tend  toward  permanency 
in  their  character.  Among  this  group  will  be  found,  property 
and  plant,  composed  of  real  estate  (technically  representing  land 
but  more  commonly  found  to  include  both  land  and  buildings), 
and  equipment  (including  machinery,  tools,  power  plant  and 
other  operating  or  auxiliary  equipment).  Other  items  in  the 
group  are  furniture  and  fixtures,  outside  investments,  comprised 
of  stocks  and  bonds  of  other  companies,  and  bonds  and  mort- 
gages of  other  companies  or  individuals. 

Working  and  trading  assets  are  those  which  represent  that 
portion  of  the  capital  which  is  invested  in  assets,  (a)  available 
for  use  in  creating  the  product,  or  service,  which  the  organiza- 
tion offers  for  sale,  (b)  involved  in  the  process  of  creating  the 
product,  or  (r)  in  product  completed  and  ready  for  sale. 
This  group  is  usually  represented  by  inventories,  and  includes 
materials  and  supplies,  goods  in  process  of  manufacture  and 
finished  goods ;  also  items  incidental  to  the  operation  or  conduct 
of  the  business,  such  as  the  inventories  of  coal,  oil,  and  waste, 
stationery,  postage,  etc. 

Current  assets  are  those  which  represent  that  portion  of  the 
capital  which  is  invested  in  assets  maturing  within  a  short  time; 
those  which  may  be  realized  upon  readily  or  converted  into  cash ; 
those  which  are  available  for  the  liquidation  of  current  Habilities. 
They  include,  cash  in  hand,  deposits,  working  funds,  accounts 
receivable,  notes  receivable,  and  interest  which  has  accrued. 
They  are  sometimes  called  "  liquid  "  assets. 

Special  or  miscellaneous  assets,  as  a  group,  are  difficult  to 
define  on  account  of  their  varied  natures.  Certain  of  them  may 
represent  investment  of  capital.     Some  of  them  may  represent 


Principles  of  Accouniirig 

reserves  or  surplus.  In  some  instances  the  accounts  may  be 
balanced  by  offsetting  accounts  reflecting  direct  liabilities  or  con- 
tingent liabilities ;  in  others,  the  account  may  be  maintained  as  a 
memorandum,  in  order  that  certain  things  may  not  be  lost  sight 
of,  and  be  balanced  by  an  offsetting  account  for  the  purpose  of 
maintaining  equilibrium.  This  group  comprises,  patents,  copy- 
rights, trademarks,  good-will,  sinking  funds,  leaseholds,  contract 
rights,  franchises,  treasury  stock,  notes  receivable  discounted, 
and  consignments  received.-  Such  items  as  patents,  copyrights, 
trademarks,  good-will,  leaseholds  and  franchises  might  represent 
investments  of  capital.  On  the  other  hand  some  of  them  might 
be  acquired  by  gift  or  by  accumulation,  in  which  cases  they 
would  probably  be  offset  by  reserves  or  surplus.  Sinking  funds 
are  usually  set  aside  to  provide  for  the  liquidation  of  some  lia- 
bility and  would  constitute  a  setting  aside  of  capital  unless  the 
funds  were  offset  by  a  reserve  accumulated  out  of  profits.  Notes 
receivable  discounted  would  be  offset  by  an  account  merely  for 
the  purpose  of  maintaining  an  equilibrium. 

Deferred  charges  to  expense,  constituting  the  last  group,  may 
be  defined  as  investments  of  capital  in  items  of  expense  not 
applicable  to  the  accounting,  or  fiscal,  period  in  which  they 
originate,  the  charge  to  expense  for  which  is  deferred  to  a  sub- 
sequent period.  They  are  sometimes  called  "  assets  by  courtesy." 
They  embrace  all  prepaid  expenses,  prominent  among  which  are, 
insurance,  taxes,  rent,  advertising,  organization  expense,  moving 
expense,  etc. 

Liabilities  may  be  divided  into  four  general  groups:  capital 
liabilities,  current  Habilities,  special  liabilities,  and  deferred  credits 
to  income.  Reserves  are  sometimes  classified  as  liabilities,  but  it 
would  appear  to  be  more  nearly  correct  to  consider  them  as  a 
portion  of  the  capital  or  proprietorship,  which  has  been  set  aside 
for  specific  purposes,  and  they  will  be  so  considered  and  treated 
in  this  discussion. 

Capital  liabilities  are  those  which  arise  in  connection  with 
capital  obtained  for  investment  in  the  business.  If  specific  at  all 
with  regard  to  their  maturity,  they  are  usually  obligations,  the 
term  of  which  extends  over  a  period  of  years.  They  are  usually 
of  such  a  nature,  that  they  do  not  become  due  until  the  date 
specified  for  their  maturity,  except  by  special  provision  in  the 
instrument  whereby  they  are  represented.    When  such  provision 

10 


Assets  and  Liabilities  Classified 

exists,  it  is  usually  in  the  form  of  a  right  accruing  to  the  holder 
of  the  obligation,  by  virtue  of  which  he  may  enforce  collection 
if  interest  on  the  obligation  is  not  paid  when  due.  Among  cap- 
ital liabilities  are  found,  bonds,  debentures,  long-term  notes,  etc. 

Current  liabilities  are  those  which  mature  within  a  short  time. 
They  are  those  for  which  funds  must  be  obtained  to  provide  for 
their  liquidation.  They  are  the  obligations  incurred  in  connec- 
tion with  operating  expenses,  the  securing  of  materials  and  sup- 
plies, the  purchase  of  trading  goods,  or  obtaining  of  current 
funds.  They  are  the  constantly  maturing  obligations  which  must 
be  met  out  of  the  realization  of  current  assets.  They  include 
such  items  as  taxes  accrued,  wages  accrued,  accounts  payable, 
notes  payable,  interest  accrued,  dividends  payable. 

Special  liabilities  are  perhaps  not  liabilities  in  a  strict  sense 
of  the  word.  Accounts  for  them  are,  however,  frequently  found 
in  the  books  and  they  should  not  be  passed  over  without  ex- 
planation. They  frequently  represent  a  condition  of  account- 
ability, rather  than  liability,  and  in  some  cases  where  a  liability 
might  be  expected  to  exist  it  is  contingent  upon  the  realization 
of  some  existing  asset.  Prominent  in  this  group  are  consigned 
sales  and  notes  receivable  discounted.  In  some  instances  it  is 
also  made  to  include  an  account  with  consignors  for  goods  re- 
ceived on  consignment. 

Deferred  credits  to  income,  represent  income  which  has  been 
received  in  a  period  prior  to  that  to  which  it  is  applicable.  In 
cases  of  this  kind  payment  has  usually  been  received  in  advance 
on  account  of  right,  services,  or  goods  which  will  not  be  deliv- 
ered until  some  subsequent  period.  They  are  sometimes  re- 
ferred to  as  deferred  liabilities  and  include  such  items  as  rents 
and  royalties,  etc.,  received  in  advance. 

Reserves  are  to  be  considered  as  capital,  set  aside  for  specific 
purposes,  rather  than  direct  liabilities.  If  it  is  true,  that  capital 
or  proprietorship  is  an  accountability,  rather  than  a  liability,  it 
is  probably  also  true  that  reserves  are  accountabilities,  rather 
than  liabilities. 

Proprietorship  is  that  financial  investment  which  is  repre- 
sented by  the  excess  of  assets  over  liabilities.  It  may  be  ex- 
pressed in  several  ways,  depending  upon  the  type  of  organization. 
It  may  be  restricted  or  unrestricted.  It  may  be  restricted,  in  that 
it  is  set  aside  as  a  reserve  for  the  purpose  of  providing  for  the 

II 


Principles  of  Accounting 

depreciation  of  some  of  the  physical  assets,  or  a  possible  loss 
through  failure  to  collect  outstanding  accounts.  As  unrestricted, 
it  may  appear  as  capital  of  the  proprietor,  or  in  the  case  of  a 
corporation,  as  capital  stock,  undistributed  profits,  or  surplus. 
As  capital  stock  it  may  be  either  common  or  preferred.  It  may 
also  be  represented  by  temporary  evidence  of  its  existence  in  the 
form  of  scrip. 

It  would  appear  to  be  appropriate  at  this  time  to  discuss  a 
question  with  regard  to  proprietorship  upon  which  there  is  some 
difference  of  opinion  among  accountants.  The  subject  for  dis- 
cussion may  be  presented  in  the  form  of  the  question  "  Is  pro- 
prietorship a  liability  ?  "  The  arguments  for  and  against,  con- 
sidering proprietorship  as  a  liability,  will  also  bring  out  the 
reason  why  English  accountants  place  liabilities  on  the  left  hand 
side  of  the  balance  sheet,  rather  than  upon  the  right  hand  side, 
as  is  the  custom  in  this  country.  Whether  or  not  proprietor- 
ship is  a  liability  depends  entirely  upon  the  viewpoint  of  the 
accountant.  It  depends  upon  whether  or  not  there  is  a  dis- 
tinction made  between  the  financial  status  of  an  individual,  as  an 
individual  and  a  business  entity.  In  other  words,  when  John 
Jones  engages  in  business,  the  question  to  be  decided  is,  shall 
he  be  regarded  as  an  individual  who  has  invested  money  in  a 
business  organization  and  which  organization  is  indebted  to  him 
for  the  funds  so  invested,  or  as  the  organization  itself?  In  order 
to  make  the  situation  conform  to  the  first  suggestion  it  is  neces- 
sary to  raise  a  theoretical  entity  in  the  form  of  John  Jones, 
Proprietor,  which  is  indebted  to  John  Jones,  Individual,  for 
funds  invested.  Under  such  circumstances  and  with  the  crea- 
tion of  such  theoretical  entity,  it  would  be  quite  proper  to  con- 
sider the  account  of  John  Jones,  Proprietor,  as  a  liabiHty,  were 
it  not  for  the  fact  that  the  law  does  not  recognize  such  a  dis- 
tinction. If  perchance  the  assets  of  John  Jones,  Proprietor,  are 
insufficient  to  liquidate  the  liabilities  of  John  Jones,  Proprietor, 
the  law  permits  any  assets  of  John  Jones,  Individual,  to  be  ap- 
propriated by  due  process  of  law  and  applied  to  the  liquidation  of 
outstanding  liabilities  of  the  business. 

Looking  at  it  from  the  other  point  of  view,  there  is  no  dis- 
tinction made  between  John  Jones,  Individual,  and  John  Jones, 
Proprietor.  John  Jones  is  the  business  ;  whatever  assets  the  busi- 
ness may  have  are  his.    Whatever  liabilities  exist  he  must  liq- 

12 


Assets  and  Liabilities  Classified 

uidate.  The  excess  of  assets  over  liabilities  constitutes  his  equity 
in  the  organization,  or  the  extent  of  his  proprietary  interest;  it 
is  his  capital.  What  he  possesses  he  cannot  very  well  be  liable 
to  himself  for.  He  cannot  sue  himself  for  the  capital  which  he 
has  invested  in  the  business.  Upon  such  grounds  it  would  ap- 
pear to  be  more  reasonable  and  logical  to  consider  proprietorship 
as  an  accountability  rather  than  a  liability.  The  positive  and 
negative  forces  of  his  business  organization  account  for  his 
financial  condition.  While  he  is  able  to  determine  his  financial 
condition  through  having  his  account  stated,  there  is  no  liability. 
He  cannot  enforce  collection.  H  he  desires  to  obtain  the  funds, 
or  the  capital,  invested  in  the  business  he  is  forced  to  wind  up 
his  afifairs  as  a  proprietor  either  through  realization  and  liquida- 
tion of  the  concern,  or  a  sale  to  other  interests. 

It  was  probably  from  the  first  interpretation  of  organization 
above  stated  that  the  English  placed  liabilities  on  the  left  hand 
side  and  assets  on  the  right  hand  side  of  the  balance  sheet.  It 
has  been  said  that  while  this  is  required  by  law  that  it  was  due 
to  ignorance  of  accounting  on  the  part  of  the  framers  of  the  law 
that  such  provision  was  made.  This  may,  or  may  not  have  been 
the  case,  but  at  all  events  such  has  become  an  established  prac- 
tice with  the  English  accountants.  The  business  is  considered 
as  a  distinct  entity,  liable  to  the  proprietor,  for  the  excess  of 
assets  over  liabilities  in  favor  of  other  creditors. 

REFERENCES  FOR  COLLATERAL  READING  t 

Accounting  Practice  and  Procedure,  Dickinson,  Chapter  II. 
Philosophy  of  Accounts,  Spra.^ue,  Chapter  XL 
Modern  Accounting,  Hatfield,  Chapter  III. 


13 


CHAPTER   IV 

NOMINAL  ACCOUNTS   CLASSIFIED 

In  connection  with  nominal  accounts  it  will  be  remembered 
that  they  were  defined  as  those  accounts  which  reflect  changes 
in  financial  condition.  The  elements  of  financial  condition  are 
assets  and  liabilities.  Nominal  accounts  reflect  changes  in  either 
assets  or  liabilities.  Assets  like  liabilities  may  either  increase  or 
decrease. 

An  increase  in  an  asset,  without  a  corresponding  increase  in 
a  liability,  or  a  decrease  in  a  liability,  without  a  corresponding 
decrease  in  an  asset,  increases  capital. 

A  decrease  in  an  asset,  without  a  corresponding  decrease  in 
a  liability,  or  an  increase  in  a  liability  without  a  corresponding 
increase  in  an  asset,  decreases  capital. 

The  increase  of  capital  is  called  profit.  The  decrease  of 
capital  is  called  loss.  Profit  may  be  the  result  of  actively  em- 
ploying the  assets  in  the  business  enterprise,  or  it  may  result 
from  an  increase  in  value,  due  to  economic  conditions  and  sub- 
sequent sale  of  the  asset.  That  class  of  profit  which  results  from 
the  employment,  with  the  object  of  direct  or  specific  return,  of  the 
assets  in  the  business  enterprise  is  distinguished  from  the  rest  by 
being  called  income. 

Income  may  be  defined  as  the  increase  in  capital  resulting 
from  its  employment  in  a  business  enterprise  or  other  invest- 
ment. It  is  sometimes  called  revenue  and  earnings.  The  capital 
may  be  either  actively  or  passively  employed.  Capital  invested 
in  goods,  sold  at  a  price  which  is  an  increase  over  what  the 
goods  cost,  for  the  purpose  of  profit,  is  an  example  of  the  active 
employment  of  capital.  Capital  invested  in  securities  for  pur- 
poses of  income  is  a  passive  employment  of  capital. 

A  business  organization  usually  engages  in  some  particular 
line  of  business.  The  efforts  of  the  organization  are  devoted  to 
the  securing  of  income  in  that  particular  line ;  from  the  sale  of 
goods;  the  sale  of  services;  the  use  of  property;  or  combinations 
in  part  or  whole  of  these.  It  is  for  the  income  from  these  that 
operations  are  conducted.  This  income  is  the  principal  or  pri- 
mary income  of  the  organization.     It  is  called  the  income  from 

4 


Nominal  Accounts  Classified 

operations.  It  is  the  income  which  arises  from  the  assets  ac- 
tively employed  in  the  business.  A  concern  employing  its  cap- 
ital in  buying  and  selling  goods,  derives  its  principal  income  from 
trading.  Incidentally  some  capital  in  the  form  of  cash  may  not 
be  constantly  required  for  use  and  is  allow^ed  to  remain  on  de- 
posit with  some  bank.  The  interest  which  the  bank  pays  for 
use  of  such  money  does  not  result  from  operations.  It  is  in- 
come but  it  does  not  come  from  trading.  No  more  does  interest 
on  funds,  which  have  been  invested  in  securities  because  the 
return  therefrom  might  be  greater  than  if  such  funds  were 
invested  in  goods,  come  from  trading.  The  hypothetical  organ- 
ization under  discussion  is  not  in  the  business  of  loaning  money. 
It  has  earned  certain  income  from  the  employment  of  surplus 
funds  in  a  manner  other  than  that  embraced  in  the  operations 
of  the  principal  business  in  which  it  is  engaged.  Such  income 
is  distinguished  from  the  principal  income  by  being  called  sec- 
ondary income,  or  income  from  sources  other  than  operation. 
The  two  combined  constitute  the  income  of  the  organization,  or 
the  net  income  from  all  sources. 

The  decrease  in  capital  is  called  loss.  Loss  may  be  of  a 
permanent  or  a  temporary  nature.  The  decline  in  the  value  of 
an  asset  due  to  economic  conditions,  from  which  it  does  not 
recover;  its  becoming  unsuited  to  the  requirements  of  the  busi- 
ness, or  its  deterioration  owing  to  lapse  of  time,  may  all  cause  a 
permanent  loss.  The  decrease  of  certain  assets,  or  the  incurring 
of  a  liability,  both  of  which  have  the  same  effect  upon  capital, 
miay  result  in  a  temporary  loss  which  presumably  will  be  re- 
stored by  the  income  from  operations  for  which  the  loss  was 
sustained.  Temporary  losses  are  distinguished  from  permanent 
ones  by  being  called  expense. 

Expense  may  be  defined  as  that  temporary  decrease  in  capital 
which  has  as  its  object  the  increase  of  capital  through  income. 
Expense  is  sometimes  called  outgo. 

Expense  may  be  divided  into  that  which  pertains  specifically 
to  operations  and  that  which  is  of  the  organization  as  a  whole. 
That  in  the  first  group,  is  called  operating  expense  or  expense 
of  operation ;  that  in  the  second,  on  account  of  being  an  expense 
applicable  to  the  business  as  a  whole  is  called  an  income  charge, 
or  a  deduction  from  income.  The  operating  expense  may  be 
further  divided.     It  falls  naturally  into  three  classes;  the  direct 

15 


Principles  of  Accounting 

expense  of  securing  the  goods,  services,  or  maintaining  the  prop- 
erty which  produces  the  income;  the  expense  of  obtaining  the 
business  or  selHng  the  product;  and  the  expense  of  administra- 
tion. The  so-called  deductions  from  income  embrace  expenses 
as  a  rule  in  connection  with  capital,  either  the  expense  of  secur- 
ing it,  or  protecting  it,  such  as  interest,  rent,  taxes,  insurance,  etc. 
From  the  foregoing,  we  may  classify  nominal  accounts  as  fol- 
lows: 

(a)  Profits  (Increases  of  Capital). 

(i)  Income. 

(a)  Primary  (from  operations). 

(b)  Secondary    (from   sources   other  than   opera- 

tion ) . 
(2)  Miscellaneous. 

(b)  Losses  (Decreases  of  Capital). 

(i)   Expense. 

(a)  Operation, 
(i)   Prime. 

(2)  Selling. 

(3)  Administration. 

(b)  Capital  (other  than  expense  of  operation). 
(2)  Miscellaneous. 

It  is  of  course  impossible  to  attempt  a  detailed  classification 
of  nominal  accounts  which  will  be  completely  exhaustive.  What 
may  be  done  is  to  give  a  classification  as  adapted  to  a  typical 
manufacturing  and  selling  organization,  including  all  the  accounts 
which  might  ordinarily  appear  therein.  Such  an  organization 
may  well  be  selected,  since  the  accounts  involved  include  a  wide 
range.  Where  accounts  are  met  with  which  differ  in  name  from 
those  appearing  in  the  classification  presented,  it  would  seem 
only  to  be  necessary  to  determine  the  real  meaning  of  the  ac- 
count in  question  and  classify  it  by  means  of  comparison  with 
other  accounts,  similar  in  their  purpose  and  about  the  names  of 
which  there  is  no  question. 

The  following  presents  a  detailed  analysis  of  the  nominal 
accounts  as  used  in  an  extensive  manufacturing  and  selling  con- 
cern, and  is  offered  principally  for  the  purpose  of  bringing  out 
clearly  the  main  divisions,  or  sources  of  profits  and  losses : 

16 


Nominal  Accounts  Classified 


Debits 

Credits 

Income  from  Sales 
(Primary  Income) 

Sales  returns 

Trade  discounts 

Allowances: 
Defective  goods 
Breakage 
Damage 
Loss 

Rebates 

Outward  freight 

Outward    cartage    (propor- 
tion of  stable  expense) 

Miscellaneous  items 

Gross  sales 

Income  from  Other 

Sources 
(Secondary  Income) 

Interest  on  bonds 
owned 

Dividends  on  stocks 
owned 

Interest  on  bond  and 
mortgage  receiv- 
able 

Cash  discount  on 
purchases 

Interest  on  bank 
balances 

Interest  on  accounts 
receivable 

Interest  on  notes  re- 
ceivable 

Rent  (receivable) 

Royalties  (receiv- 
able) 

Commission  (receiv- 
able) 

Consideration  for  en- 
dorsing notes 

Accumulation  of  dis- 
count on  bonds 

Miscellaneous  Profits 

- 

Sales  of 
Land  or  buildings 
Machinery  or  tools 
Horses,  wagons  or 

harness 
Furniture   or  fix- 
tures 
Securities 
Materials  and  sup- 
plies 
Amounts   previously 
written    off  — now 
collected 
Appreciation  of  land 
Appreciation  of  se- 
curities 

17 


Principles  of  Accounting 


Debits 

Credits 

Expense  of  Operation 
(Prime) 
(Cost  of  Sales) 

Materials  and  supplies 

Gross  purchases 
Inward  freight 
Inward  cartage  (proportion 

of  stable  expense) 
Salaries     and     expenses — 

Purchasing  department 
Labor — Direct 
Labor — Indirect 
Foremen 

Laborers  and  helpers 
Factory  expense 
Superintendence 
Clerks     (keeping    factory 

records) 
Factory  office  expense 
Heat,  light  and  power 
Factory  supplies 
Repairs  and  renewals  of 
shop   tools  and   minor 
equipment 
Depreciation  of  machinery 
and  other  major  equip- 
ment 

Purchase  returns 
Trade  discounts 
Allowances 
Rebates 

Expense  of  Operation 
(SeUing) 

Sales  department  expenses 
Salary  sales  manager 
Salaries  of  clerks 
Office  expenses 
Salesmen 
Salaries 
Traveling 
Commissions 
Advertising 
Entertaining  customers 

Expense  of  Operation 
(Administration) 

Salaries  of  officers 

Salaries  of  clerks   (keeping 

general  records) 
Directors'  fees 
Printing  and  stationery 
Postage 

Telephone  and  telegraph 
Traveling — officers  and  clerks 
Legal  expenses 
Miscellaneous  office  expenses 

Expenses   Other   than 
those  of  Operation 
(Capital  Expenses) 

Interest  on  bond  and  mort- 
gage payable 

Interest  on  debentures  or  in- 
come bonds 

Interest  on  accounts  payable 

Interest  on  notes  payable 

Interest  on  loans  payable 

Cash  discount  on  sales 

Rent  (payable) 

Insurance  expense 

Taxes 

Interest  on  capital 

Royalties  (payable) 

i8 


Nominal  Accounts  Classified 


Miscellaneous  Losses 


Debits 


Sales  of 
Land  or  buildings 
Machinery  or  tools 
Horses,  wagons  or  harness 
Furniture  or  fixtures 
Securities 
Materials  and  supplies 

Provision  for  doubtful  ac- 
counts 

Depreciation  of  buildings 

Amortization   of  patents, 
trademarks  or  goodwill 

Organization    Expense — 
written  off 


Credits 


Dividends  have  not  been  included  in  the  above  for  specific 
reason.  They  are  analogous  to  the  distribution  of  profits  in  a 
sole-proprietorship  or  copartnership. 

If  a  proprietor  withdraws  $10,000  from  his  business,  it  is 
true  the  amount  has  been  lost  so  far  as  the  business  is  concerned. 
The  capital  has  been  accordingly  reduced.  We  should  not,  how- 
ever, consider  it  as  a  loss  to  the  business,  if  at  the  same  time  of 
the  withdrawal,  it  had  been  determined  that  the  profits  for  the 
year  were  $12,000.  We  should  look  upon  the  withdrawal  as  the 
distribution  of  profit  rather  than  a  loss.  So  should  dividends  be 
regarded  as  a  distribution  of  profit,  rather  than  a  loss,  since  they 
will  not  be  distributed  as  such  unless  a  profit  has  resulted  from 
the  business  operations. 

REFERENCES  FOR  COLLATERAL  READING! 

Philosophy  of  Accounts,  Sprague,  Chapters  XII-XIV. 
Accounting  Practice  and  Procedure,  Dickinson,  Chapter  III. 
Modern  Accounting,  Hatfield,  Chapter  XV. 


19 


Principles  of  Accounting 
CHAPTER   V 

SPECTAL  FUNCTIONS  OF  CERTAIN  ACCOUNTS 

While  most  accounts  are  kept  for  the  purpose  of  classifying 
the  records  of  financial  transactions,  there  are  certain  classes  of 
accounts  which  are  sort  of  supplementary  or  secondary  in  their 
purpose  and  certain  classes  of  accounts  which  have  functions 
added  to  those  which  they  originally  had. 

In  the  first  class  are  included  group  accounts,  summary  ac- 
counts, statistical  or  administrative  accounts,  and  general  ac- 
counts. In  the  second  class  the  most  striking  example  is  the 
controlling  account. 

A  group  account  is  one  into  which  a  number  of  detail  ac- 
counts are  closed  for  the  purpose  of  determining  the  status  of 
a  general  factor  in  the  economic  result.  For  example :  profit  and 
loss  shows  the  economic  result.  The  general  factors  bearing 
upon  the  result  are,  income  from  saltb,  cost  of  sales,  selling  ex 
pense,  administrative  expense,  etc.  The  account — income  from 
sales — is  made  up  of  various  detail  accounts  of  which  there  are 
gross  sales  on  the  credit  side,  and  the  returns  together  with  the 
deductions  from  sales  on  the  debit  side. 

A  summary  account,  as  its  name  implies,  summarizes  a  series 
of  accounts  of  a  general  nature  and  shows  the  net  result  in  totals 
of  the  field  of  accounts  which  it  covers.  The  profit  and  loss 
account,  as  above  mentioned,  illustrates  a  summary  account, 
showing  after  it  has  been  closed,  on  the  credit  side,  income  from 
sales,  income  from  sources  other  than  sales,  and  miscellaneous 
profits,  and  on  the  debit  side  cost  of  sales,  selling  expense,  adminis- 
trative expense,  deductions  from  income,  miscellaneous  losses 
and  withdrawals  or  dividends. 

A  statistical,  or  administrative  account,  is  a  group  account 
which  gathers  together  the  information  necessary  to  exhibit  a 
specific  result  following  certain  transactions.  Examples  of  this 
are  a  manufacturing  account,  a  trading  account,  a  contract 
account,  showing  the  gain  or  loss  on  a  certain  contract,  etc. 

20 


special  Functions  of  Certain  Accounts 


A  general  account  is  a  bookkeeping  device  for  balancing  a 
number  of  detail  accounts.     It  is  always  of  an  opposing  ten- 


Dn 


ConfrolUng 
Account 


Cr. 


Getxeral 
Account 


dency  to  the  detail  accounts.  The  keeper  of  a  customers'  ledger, 
in  which  case  the  aggregate  of  the  detail  accounts  would  be  of  a 
debit  nature,  might  keep  his  ledger  in  balance  by  running  in  the 
back  of  the  book  a  general  account,  wherein  he  would  post  as  a 
credit,  the  total  of  a  number  of  debits  which  he  had  posted  in 
detail  to  the  individual  customers'  accounts  and  vice  versa.  In 
so  far  as  the  items  which  have  been  furnished  him  are  concerned, 
he  would  have  no  occasion  to  consult  the  controlling  account  in 
the  general  ledger,  in  order  to  determine  whether  or  not  his  ledger 
was  in  balance. 

The  accounts  receivable  account  is  a  real  account,  which  is 
an  asset.  It  shows  the  amount  due  from  customers  presumably. 
It  is  quite  customary  for  this  account  to  have  an  added  function, 
namely,  that  of  a  controlling  account. 

A  controlling  account  is  an  account  appearing  in  the  general 
ledger,  which  reflects,  in  total,  the  condition  of  two  or  more 
detail  accounts,  of  the  same  tendency  as  the  controlling  account. 
It  is  to  be  distinguished  from  a  general  account  in  that  while  it 
shows  the  same  mathematical  result  the  result  is  of  an  opposite 
tendency. 

The  prime  object  of  a  controlling  account  is  conciseness. 
It  is  not  always  convenient  to  wait  for  a  large  number  of  indi- 
vidual accounts  to  be  balanced  in  order  that  the  result  with 
regard  to  these  accounts  as  a  whole  may  be  known.  It  is  fre- 
quently necessary  to  close  the  general  books  and  prepare  the 

21 


Principles  of  Accounting 

financial  statements  before  the  detail  work  of  posting  the  under- 
lying ledgers  is  completed. 

In  addition  to  conciseness,  the  controlling  account  offers  an 
opportunity  for  a  division  of  the  bookkeeping  work  and  gives 
the  general  bookkeeper  at  the  same  time  an  opportunity  to  con- 
trol the  detail  work  which  he  assigns  to  his  assistants.  What 
he  does  in  total  they  are  obliged  to  do  in  detail.  When  he 
makes  a  charge  to  the  controlling  account  for  sales  to  customers 
they  are  required  to  make  the  charges  to  the  individual  cus- 
tomers' accounts.  When,  at  the  end  of  the  month,  he  makes  a 
total  credit  from  the  cash  book  of  remittances  from  customers, 
and  the  other  necessary  entries  for  returns,  allowances,  etc.,  he 
is  enabled,  as  soon  as  trial  balances  of  the  customers'  ledgers 
are  submitted  to  him,  to  tell  whether  or  not  the  assistant  is  doing 
his  work  faithfully  and  from  the  standpoint  of  mathematical 
results  correctly.  A  controlling  account  will  not  prevent  a  book- 
keeper from  posting  an  item  to  a  wrong  account  any  more  than 
systems  of  bookkeeping  will  prevent  dishonesty.  Neither  will 
the  controlling  account  discover  such  mistakes.  It  does  assist  in 
the  discovery  of  mathematical  errors,  however,  by  offering  an 
opportunity  for  the  localization  of  the  error. 

As  to  the  order  in  which  accounts  should  be  arranged  in  the 
general  ledger,  apparently,  just  a  word  is  necessary.  If  it  is 
definitely  known  that  the  information  as  to  financial  transactions 
is  to  be  set  forth  in  certain  financial  statements  and  that  in  order 
to  convey  the  information  intelligently  and  in  the  manner  which 
will  be  most  useful  to  the  person  to  whom  it  is  furnished,  then 
it  would  seem  that  some  provision  should  be  made  for  getting 
at  this  information  with  the  least  possible  effort.  Planning  is 
one  of  the  essential  elements  of  scientific  management.  Planning 
should  be  one  of  the  most  essential  elements  of  scientific  account- 
ing. Columnar  books  were  the  improved  machinery  which  made 
the  classification  of  transactions  possible  and  prevented  tiresome 
and  time-consuming  analysis  necessary.  The  proper  arrangement 
of  the  accounts  in  the  general  ledger  will  do  wonders  toward 
facilitating  the  preparation  of  financial  statements.  In  a  word 
or  two  the  rule  may  be  thus  stated:  as  far  as  possible,  observe 
the  same  order  of  arrangement  in  the  general  ledger  as  that  in 
which  the  results  shown  by  the  accounts  will  appear  in  the 
financial  statements. 

22 


CHAPTER   VI 

THE   PROPERTY   ACCOUNTS 

Among  the  accounts  prominent  in  all  lines  of  business  are  the 
so-called  "  property  accounts."  This  has  become  a  common 
term,  although  it  is  probably  to  be  criticized  in  that  it  is  not 
sufficiently  specific.  It  includes,  as  a  rule,  land,  buildings  and 
equipment.  It  is  too  frequently  confused  by  being  called  real 
estate,  real  property,  property  and  plant,  etc.  These  terms  while 
not  so  bad  perhaps  when  used  as  general  descriptive  titles  in 
financial  statements  have  no  place  in  the  books  as  account  titles. 
An  abundance  of  accounts  is  preferable  to  a  scarcity.  Not  much 
time  is  gained  by  economizing  in  the  number  of  accounts  and 
much  time  and  useful  information  is  many  times  subsequently 
lost  by  this  procedure.  It  is  easier  to  combine  than  to  separate. 
Combination  is  the  rule  in  financial  statements  because  of  their 
general  nature.  Division  should  be  the  rule  as  to  the  means  of 
securing  the  information. 

Thus  it  is  proposed  in  the  discussion  of  property  accounts 
to  look  at  the  items  which  may  unquestionably  come  under  prop- 
erty and  take  up  one  by  one  the  accounts  representing  these 
items. 

An  analysis  of  the  possibilities  which  the  word  embraces 
would  include  in  general  t^rms  land,  buildings,  machinery,  tools, 
equipment,  horses,  wagons  and  harness,  automobiles,  and  fumi^ 
ture  and  fixtures. 

Land  is  sometimes  referred  to  as  real  property.  Real  prop- 
erty is  a  technical  legal  word.  "  Property  is  the  right  to  possess 
and  use."  "  Real  property  is  the  right  to  possess  and  use  land  " 
for  an  indefinite  period  of  time.  Land  is  also  sometimes  referred 
to  as  real  estate,  but  this  term  like  so  many  others  applied  to 
land  and  buildings  is  confusing,  for  the  reason,  that  the  term 
real  estate  is  also  used  to  designate  a  business,  the  object  of 
which  is  to  deal  in  real  property  and  those  chattel  interests  which 
attach  to  real  property  such  as  leases  and  leasing,  mortgages  and 
liens.  All  confusion  may  be  avoided  by  not  using  any  of  these 
terms  and  merely  referring  to  land  as  such. 

Since  accounting  follows  bookkeeping  and  bookkeeping  fol- 

23 


Principles  of  Accounting 

lows  the  business  transactions,  it  will  no  doubt  be  of  interest 
in  discussing  the  account  for  land  and  the  manner  in  which  the 
account  is  manipulated,  to  examine  the  subject  of  the  account  with 
regard  to — how  it  may  be  acquired,  either  permanently  and  tem- 
porarily, what  may  happen  to  it,  and  how  it  may  be  disposed  of. 

Land  may  be  acquired  by  inheritance,  purchase  or  gift.  In 
some  cases  it  may  be  improved  by  reclaiming  or  draining,  and 
in  others  by  filling  in  or  making  new  land.  It  will  probably  be 
seen  immediately  that  all  of  these  possibilities  might  exist  and 
that  all  have  a  distinct  bearing  upon  the  accounting.  In  any 
case  the  permanent  acquisition  of  land  is  accompanied  by  a  deed 
which  vests  title  in  the  holder  thereof.  Land  acquired  by  gift  or 
inheritance  has  a  very  different  effect  upon  the  accounts  from 
that  which  is  purchased,  made  or  reclaimed.  Land  which  is 
purchased  will  be  acquired  either  for  cash  or  through  credit. 
The  credit  may  take  the  form  of  an  open  account  or  may  be 
represented  by  a  mortgage.  The  purchaser  may  take  the  land 
subject  to  the  mortgage  or  he  may  assume  the  mortgage.  Where 
land  is  made  or  reclaimed  there  are  certain  expenses  incident  to 
its  improvement  which  may  add  to  the  first  cost  or  perhaps  the 
entire  cost.  In  just  these  few  simple  statements  the  acquisition 
of  land  has  brought  sharply  to  the  attention  the  fact  that  it  is 
closely  related  to  bookkeeping,  accounting,  law  and  finance. 

The  holder  of  land  is  brought  into  direct  contact  with  the 
government  through  its  ownership.  The  government  affords 
police  protection  to  its  citizens  and  in  return  exacts  a  tax  for 
such  service  and  the  general  maintenance  of  the  government. 
Taxes  will  be  treated  at  length  in  another  chapter.  In  addition 
to  the  right  to  taxation  which  the  state  claims,  there  is  what  is 
known  as  the  right  of  eminent  domain.  This  is  the  right  to 
confiscate  any  property  which  may  be  needed  for  the  common 
good.  Included  under  such  necessities,  are  thoroughfares,  pro- 
jected railroad  lines,  and  street  car  systems.  While  such  pro- 
ceedings are  possible  under  the  right  granted  him  by  the  con- 
stitution of  the  United  States,  the  holder  must  be  given  an  op- 
portunity to  be  heard  and  he  must  be  paid  a  fair  compensation 
for  his  land. 

In  the  absence  of  ownership,  land  may  be  hired  or  it  may  be 
leased.  The  distinction  between  hiring  and  leasing  seems  to  be, 
that  hiring  implies  as  a  rule  a  verbal  contract  from  month  to 

24 


The  Property  Accounts 

month,  or  from  one  short  period  of  time  to  another;  whereas 
leasing  carries  with  it  a  written  contract  with  certain  express  and 
impHed  conditions  and  usually  covers  a  longer  period  of  time; 
for  example,  a  year,  five  years  or  ten  years. 

At  first  thought,  it  would  not  seem  that  much  of  consequence 
could  happen  to  land.  Upon  further  investigation  it  will  be 
quite  plain  that  economic  conditions  may  have  a  very  great  effect 
upon  land.  A  given  locality,  perfectly  adapted  to  certain  lines 
of  business  to-day,  may  within  ten  years  be  entirely  unsuited  to 
the  needs  of  the  same  Hne  of  business.  Land  which  is  of  no 
particular  value  to-day  may  within  the  same  period  of  time  be- 
come exceedingly  high  in  price  owing  to  the  demand.  Thus, 
land  may  either  appreciate  or  depreciate  in  value.  If  the  owner 
of  the  land  does  not  pay  his  taxes  or  his  other  obligations,  the 
state  may  impose  a  lien,  or  the  courts  may  take  similar  action 
in  favor  of  some  judgment  creditor.  The  holder  of  a  mortgage 
may  foreclose  and  take  title. 

Land  may  be  a  direct  factor  in  the  production  of  income  or 
it  may  be  an  indirect  factor.  As  the  part  of  the  property  of  a 
business  organization  it  is  an  indirect  factor  in  the  production 
of  income  in  the  form  of  profits.  Remembering  that  land  in- 
cludes not  only  the  surface,  but  the  natural  resources  above  and 
below  the  surface,  it  may  be  a  direct  factor  in  the  production 
of  income  in  the  case  of  mining,  hunting,  fishing,  forestry,  and 
water  power.  The  income  may  be  obtained  through  any  one  of 
these  extractive  industries  or  by  temporarily  assigning  these 
rights  to  others  in  consideration  of  rent. 

Land  may  be  disposed  of  by  sale,  for  cash  or  on  credit;  on 
account,  through  an  unsecured  claim  or  through  a  mortgage; 
by  sale  through  foreclosure  either  in  the  case  of  a  mortgage,  tax, 
or  other  lien. 

The  application  of  the  above  principles  may  be  seen  in  the 
following  test : 

Applied  Theory  Test  Number  One 

James  Morrison,  being  in  business  for  himself,  inherits  from 
his  father  certain  land  (Parcel  A)  which  can  be  used  to  ad- 
vantage in  the  business.  It  was  valued  in  the  inventory  of  the 
estate  at  $10,000.     He  purchases  one  additional  parcel  of  land 

25 


Principles  of  Accounting 

(Parcel  B)  for  $15,000  paying  $8,000  in  cash,  giving  a  purchase 
money  mortgage  for  the  balance  and  taking  it  subject  to  a 
mortgage  of  $4,000.  On  another  parcel  (Parcel  C)  he  purchases 
the  land  for  $20,000  paying  $1,000  in  cash,  assuming  a  mort- 
gage of  $5,000,  and  giving  a  purchase  money  mortgage  for  the 
balance.  He  receives  gratis  from  a  neighboring  town  a  parcel 
(Parcel  D)  for  a  manufacturing  plant.  This  plot  is  low  and 
swampy  and  requires  draining  and  filling  in  which  cost  $2,500 
but  was  held  by  a  former  owner  at  $4,000.  It  subsequently  ap- 
preciated in  value  $7,500,  while  Parcel  B  depreciated  $2,000. 
One-half  of  Parcel  A  was  taken  by  the  state  under  the  right 
of  eminent  domain,  at  an  appraised  value  equal  to  cost.  Parcel 
D  was  sold  by  the  state  under  a  tax  lien  realizing  for  Morrison 
$11,000  and  the  mortgagee  foreclosed  on  Parcel  C  selling  it  for 
$13,000. 

Frame  the  journal  entries  necessary  to  express  the  preceding 
transactions. 

REFERENCES  FOR  COLLATERAL  READING: 

Modern  Accounting,  Hatfield,  pages  86-87. 
Accounting  Practice  and  Procedure,  Dickinson,  pages  76-77. 
Science  of  Accounts,  Bentley,  pages  139-142. 
Auditing  Theory  and  Practice,  Montgomery,  pages  119,  331, 
494. 

Journal  of  Accountancy,  Vol  VI H,  page  237. 


26 


CHAPTER   VII 

BUILDINGS 

Buildings  present  a  somewhat  different  subject  for  discussion 
than  land.  They  are  subject  to  a  greater  variety  of  possibilities 
than  land,  since  it  may  almost  be  said  of  land  that  it  cannot  be 
carried  away  or  destroyed,  which  is  not  true  of  buildings. 

A  new  concern  about  to  engage  in  business  and  seeking  build- 
ings for  such  purposes  has  a  choice  of  two  means  of  securing 
them.  They  may  be  constructed  anew  or  they  may  be  pur- 
chased. If  not  adapted  to  the  needs  of  the  business  they  may 
be  altered  to  meet  the  demands. 

Construction,  presumably,  is  the  method  to  be  preferred. 
Having  acquired  the  land  upon  which  to  place  the  building,  the 
concern  may  proceed  in  one  of  three  ways.  The  first  is  to  pur- 
chase the  material,  engage  the  necessary  workmen  and  supervise 
the  construction.  This  statement  while  generally  true  should  be 
qualified  in  one  or  two  particulars.  In  New  York  City,  and 
probably  in  all  the  other  large  cities  of  the  United  States,  the 
building  department  of  the  city  requires  that  the  plans  shall  be 
drawn  by,  or  under  the  direction  of,  an  architect.  In  some 
cases  where  engineering  construction  is  involved  the  plans  must 
be  made  by  an  engineer. 

As  an  alternative  a  contract  may  be  made  with  some  builder 
to  erect  the  building.  By  this  is  meant  an  individual  or  concern 
which  will  take  over  the  entire  work  of  construction  and  be 
responsible  for  its  completion.  The  plans  may  be  obtained  from 
an  architect  and  furnished  to  the  builder  to  follow. 

As  a  second  alternative  the  work  may  be  turned  over  to  an 
architect  who  will  attend  to  the  drawing  of  the  plans,  the  letting 
of  the  contracts  and  sub-contracts,  and  the  supervision  of  the 
work  as  it  progresses.  In  this  latter  case  it  is  customary  for  the 
concern,  for  which  this  work  is  being  done  and  which  is  called 
the  client  of  the  architect,  to  make  payments  to  the  construction 
company  or  the  contractors  upon  certificates  of  the  architect  as 
portions  of  the  work  are  from  time  to  time  completed. 

The  architect  receives  for  his  services  a  fee  which  is  based 
on  a  percentage  of  the  cost  of  the  work  done.     The  rate  for 

27 


Principles  of  Accounting 

general  work  as  established  by  the  American  Institute  of  Archi- 
tects is  six  (6)  per  cent.  The  service  which  this  rate  covers 
includes  the  necessary  conferences,  preparation  of  preliminary 
studies,  working  drawings,  specifications,  large  and  full  size  de- 
tail drawings  and  the  general  direction  and  supervision  of  the 
work.  The  rate  varies  according  to  the  class  of  work,  ranging 
from  six  per  cent  as  above  to  fifteen  (15)  per  cent  in  the  case 
of  designs  for  fabrics  or  special  decorative  work  and  is  higher 
for  work  outside,  than  inside,  the  city. 

The  architect  is  becoming  an  important  factor  in  the  new 
construction  work  of  to-day,  especially  in  the  larger  cities. 
Where  formerly  perhaps  the  scope  of  his  work  was  limited  to 
the  drawing  of  the  plans,  to-day,  as  a  rule,  he  is  the  building 
specialist,  who  combines  his  technical  skill  with  artistic  taste  for 
the  best  interests  of  his  client  and  superintends  the  work  from 
beginning  to  end.  Among  his  duties  in  addition  to  preparing  the 
plans  are  those  of  determining  the  location  of  the  building;  the 
quality  of  the  soil  on  which  the  foundations  are  to  rest;  filing 
the  plans  with  the  building  departments  and  securing  their  ap- 
proval; getting  the  necessary  permits  to  begin  operations,  ob- 
struct the  streets,  open  the  streets  for  gas,  sewer,  and  electric 
connection,  etc.  As  to  the  installation  of  electricity  he  must 
secure  permission  from  the  Department  of  Water,  Gas  and 
Electricity  and  the  Board  of  Fire  Underwriters.  Further,  he 
must  see  that  there  are  no  violations  of  the  rules  and  regulations 
affecting  the  public  health. 

One  point  in  connection  with  building  operations  and  one 
which  should  have  a  decided  effect  upon  the  accounting  is  that 
of  the  acceptance  of  the  work.  The  risk  for  employer's  lia- 
bility and  for  fire  is  with  the  contractor  until  the  work  has  been 
accepted  by  the  client.  Two  things  would  appear  to  be  certain. 
First,  payment  on  account  of  the  contract  price  is  a  matter  of 
convenience  and  does  not  imply  acceptance  of  the  work.  Sec- 
ond, the  liability  of  the  client  to  the  contractor  does  not  rise, 
even  after  the  signing  of  the  contract  until  the  contractor  has 
complied  with  the  terms  of  the  contract  and  performed  the  work 
required  of  him.  Hence  it  would  seem  to  represent  something 
not  true  as  to  facts  if  at  the  time  of  signing  the  contract,  the 
contract  price  were  to  be  recorded  on  the  books  as  showing  the 
cost  of  the  construction  and  the  corresponding  liability  to  the 

28 


Buildings 

contractor.  What  would  appear  if  such  a  thing  were  to  be 
done  would  be  a  so-called  contingent  asset  on  one  side,  offset 
by  a  contingent  liability.  It  would  probably  be  expressing  it 
more  correctly  to  say  that  two  statistical  accounts,  having  as  their 
basis  the  contract  price,  have  been  raised,  not  to  record  facts 
but  to  provide  for  the  recording  of  possibilities.  The  method 
which  would  seem  to  be  more  correct  would  be  to  charge — cost  of 
contract  and  credit — the  contractor,  when  estimates  certified  by 
the  architect  are  received,  closing  out  the  liability  in  favor  of 
the  contractor  when  the  payment  to  him  is  made.  One  of  these 
steps  might  be  eliminated  also  by  charging  the  contract  account 
direct  and  crediting  cash  at  the  time  the  payment  of  the  estimate 
is  made.  A  summary  of  the  two  ways  of  handling  the  matter 
would  show  as  follows: 

First  Method: 

First  Step.  Charge  a  contract  account  with  the  con- 
tract price. 

Second  Step.  Credit  the  contractor  in  a  similar 
amount. 

Third  Step.  As  estimates  are  paid  charge  the  con- 
tractor and  credit  cash. 

Result.  The  account  with  the  contractor  will  be 
closed  and  the  contract  account  remaining 
open  will  show  the  cost  of  the  construction. 

Second  Method: 

First  Step.  As  estimates  are  certified  by  the  archi- 
tect, charge  the  contract  account  and  credit 
the  contractor. 

Second  Step.  As  estimates  are  paid,  charge  con- 
tractor and  credit  cash. 

Result.    Same  as  first  method. 

One  point  in  connection  with  the  final  payment  on  contracts 
arises  regardless  of  which  method  is  employed.  That  is  the 
amount  which  is  reserved  by  the  client  to  protect  himself  against 
defective  work.  Such  a  reserve  is  customary  in  contract  work 
and  is  sometimes  withheld  for  a  year  or  more.  The  effect  which 
such  procedure  would  have  on  the  second  method  is  apparent. 
Pending  final  payment  the  contract  account  will  not  show  the 
total  cost  of  the  work  which  information  might  be  needed  for 

29 


Principles  of  Accounting 

various  purposes  prior  to  final  settlement.  On  the  other  hand  it 
is  not  desirable  to  charge  the  contract  and  credit  the  contractor 
with  the  amount  retained  since  it  may  not  be  a  liability  in  his 
favor  if  defective  or  unsatisfactory  work  is  discovered  subse- 
quent to  the  completion  of  the  work.  Both  ends  may  be  served 
by  charging  the  contract  and  crediting  a  reserve  for  defective 
work,  or  an  account  with  some  other  appropriate  title. 

To  leave  the  matter  of  contracts,  while  having  discussed  them 
from  the  side  of  the  client  only,  would  seem  to  leave  the  sub- 
ject only  half  completed.  Apparently,  to  find  a  more  appro- 
priate time  to  consider  this  phase  of  contracts  would  be  difficult. 

Approaching  the  subject  from  the  point  of  view  of  the  con- 
tractor, he  appears  to  be  in  this  position:  he  holds  a  contract 
under  which  he  is  to  do  certain  work  and  from  which  presumably 
he  will  derive  some  profit.  With  him  it  is  largely  a  question  of 
whether  he  shall  consider  a  profit  as  earned  until  the  contract 
is  completed  and  the  actual  cost  determined  and  if  so  how  the 
earnings  shall  be  taken  up  with  regard  to  periods. 

The  price  at  which  a  contractor  agrees  to  do  a  certain  piece 
of  work  is  presumably  made  up  of  two  parts,  namely,  cost  and 
profit.  Taking  for  example  a  contract  in  which  the  price  is 
$10,000,  made  up  of  an  estimated  cost  of  $8,000  and  an  esti- 
mated profit  of  $2,000,  it  would  appear  that  when  the  contract 
is  one-half  completed,  if  the  actual  cost  has  not  exceeded  $4,000, 
the  contractor  is  entitled  to  take  up  a  profit  of  $1,000.  In  other 
words,  he  appears  to  be  entitled  to  take  into  his  earnings,  one- 
half  of  the  contract  price,  or  $5,000.  In  an  ideal  case  such  as 
this  is,  it  is  not  probable  that  any  objection  could  be  raised  to 
this  procedure.  Two  things  in  practice,  however,  complicate 
matters. 

Many  contractors,  while  making  estimates  on  individual  jobs, 
do  not  keep  accurate  records  showing  the  actual  cost  of  the 
individual  jobs,  and  in  some  cases  do  not  keep  records  at  all. 
Thus  it  is  impossible  in  such  cases  to  determine  from  the  cost 
records  the  stage  of  completion  which  has  been  reached  when 
the  general  books  are  closed.  By  this  is  meant  whether  the  con- 
tract is  one-half  or  two-thirds  completed,  or  whatever  the  stage 
may  be. 

In  a  large  concern  having  several  contracts  there  will  be  a 
variation  in  the  length  of  time  required  to  do  the  different  jobs, 

30 


Buildings 

so  that  no  exact  data  as  to  the  stage  of  completion  can,  in  the 
absence  of  a  cost  system,  be  obtained.  If  the  contractor  decides 
to  take  up  a  part  of  the  earnings  before  completion,  the  per- 
centage to  be  taken  up  will  necessarily  be  based  on  an  estimate 
which  should  be  an  average  of  the  various  stages  of  completion 
of  all  contracts. 

In  addition  to  the  above  two  complications  it  may  be  men- 
tioned that  the  second  half  of  a  contract  may  be  the  part  which 
will  prove  destructive  to  the  profits.  At  a  stage  of  half  com- 
pletion the  actual  cost  may  have  been  kept  within  the  estimated 
cost  and  one-half  of  the  earning  and  accompanying  profit  quite 
properly  taken  up.  In  completing  the  contract  the  balance  of  the 
estimated  cost  may  be  so  greatly  exceeded  as  to  wipe  out  not 
only  the  profit  corresponding  to  the  latter  one-half  but  also  that 
pertaining  to  the  former  part. 

As  contrasted  with  the  practice  of  taking  a  percentage  of  the 
contract  price  into  earnings  before  completion,  there  exists  the 
practice  of  deferring  such  an  operation  until  the  contract  is  com- 
pleted. This  practice  meets  with  the  objection  that  the  cost  is 
not  consistently  applied  against  the  income.  Under  such  methods 
it  would  be  possible  to  have  a  case  wherein  all  the  cost  with 
no  income,  would  appear  in  one  accounting  period,  whereas  in 
the  succeeding  period  all  the  income,  with  no  cost,  might  be 
shown. 

While  such  an  occurrence  is  possible  it  is  rather  improbable 
and  many  accountants  are  inclined  to  the  opinion,  that  as  be- 
tween periods  the  two  factors  will  be  "  averaged  up." 

One  more  point  should,  it  seems,  be  discussed  before  leaving 
this  topic.  The  two  previous  cases  were  based  on  the  assump- 
tion that,  upon  the  signing  of  the  contract,  or  as  estimates  had 
been  rendered,  charges  had  been  made  to  the  customer's  account 
in  the  amount  of  the  contract  price  and  some  account,  the  name 
of  which  at  this  time  is  unimportant,  had  been  credited.  In  this 
case  it  may  be  assumed  that  such  a  step  is  deferred  until  the 
contract  is  practically  completed.  As  estimates  are  rendered  no 
record  is  made  in  the  financial  books.  When  the  estimates  are 
paid,  cash  is  charged  and  the  customer's  account  credited.  When 
the  contract  is  completed,  the  customer  is  charged  with  the  full 
contract  price  and  the  earning  account  is  credited. 

All  of  the  above  cases  have  been  founded  on  building  and 

31 


Principles  of  Accounting 

similar  contracts  where  payments  on  account,  or  estimates,  as 
they  are  called,  affect  the  bookkeeping.  The  above  remarks  are 
equally  applicable  to  other  kinds  of  contracts,  such,  for  instance, 
as  an  accountant  would  make  with  a  client.  The  variation  is 
slight  in  such  cases  and  consists  principally  in  substituting  tem- 
porarily for  the  client's  account,  one  termed,  unfinished  con- 
tracts or  unfinished  engagements.  This  offers  an  opportunity 
for  building  up  or  adjusting  the  charges  to  the  customer's  ac- 
count until  the  contract  or  engagement  is  completed. 

No  matter  which  method  is  adopted  the  contractor  must  make 
provision  for  an  appropriate  reserve  if  the  customer  retains  a 
certain  percentage  for  defective  work  after  completion.  The 
manner  in  which  this  is  accomplished  depends  upon  whether  the 
contracts  are  entered  in  total  or  by  estimates  and  whether  the 
estimates  are  entered  gross  or  net. 

An  entry  to  cover  this  reserve  would  be  necessary  upon  com- 
pletion of  the  contract  were  the  estimates  to  be  entered  net. 
Were  they  to  be  entered  broad,  or  gross,  the  reserve  would  be 
automatically  built  up  from  time  to  time.  To  explain  this,  let 
it  be  assumed  that  the  first  estimate  on  a  $40,000  contract  is  as 
follows : 

To  material  and  labor  supplied  in  the  con- 
struction of  factory  building  at  Flushing, 
Long  Island $6,550 

Less  10%  655 

Amount  due $5,895 


The  estimate  after  being  approved  or  certified  by  the  architect, 
or  his  inspector,  goes  to  the  customer.  If  the  contract  price  is 
$40,000  then  it  will  be  plain  that  upon  completion  the  various  de- 
ductions will  have  accumulated  so  that  $36,000  will  have  been 
paid  and  $4,000  withheld. 

If  the  estimates  are  entered  net,  the  account  with  the  customer 
will  have  been  charged  with  $36,000  and  the  earnings  account 
credited  with  a  corresponding  amount.  It  will  then  be  necessary 
to  make  a  final  entry  charging  the  customer's  account  and  credit- 
ing the  reserve  in  the  amount  of  $4,000. 

32 


Buildings 

If  the  estimates  had  been  entered  broad,  the  entry  in  the  in- 
stance of  the  above  estimate  would  have  charged  the  customer 
with  $6,550  and  credited  earnings  with  $5,895  while  the  reserve 
account  was  credited  with  $655.  Subsequently  as  estimates  were 
made,  ten  per  cent  would  have  been  credited  to  the  reserve  so 
that  at  the  end  of  the  contract,  the  customer's  account  would 
have  been  charged  with  $40,000,  an  amount  of  $36,000  credited 
to  earnings  and  $4,000  to  the  reserve.  No  further  entry  would 
then  be  necessary  for  this  purpose. 

The  question  may  now  arise  as  to  the  amount  of  $4,000 
standing  in  the  customer's  account,  and  offset  by  a  reserve  of 
$4,000,  as  to  its  status  from  an  accounting  point  of  view.  May 
it  be  looked  upon  as  a  positive  or  as  a  contingent  asset? 

The  reserve  has  been  created  because  of  an  uncertainty  in 
collecting  the  amount  from  the  customer.  Failure  to  collect  it 
may  be  due  to  defective  work.  If  defects  arise,  the  customer 
will  usually  notify  the  contractor  who  will  proceed  to  make  the 
work  satisfactory,  after  which  time  the  contractor  may  collect 
the  balance  due  him. 

If  the  contractor  refuses  to  make  good  the  defect,  or  correct 
something  which  has  proven  unsatisfactory,  the  contract  usually 
provides  that  the  customer  may  cause  the  necessary  work  to  be 
done  and  pay  for  same  out  of  the  funds  of  the  contractor  which 
he  has  retained.  Any  balance  remaining  will  then  be  paid  over 
to  the  contractor.  If  the  funds  prove  insufficient  a  demand  for 
additional  funds  will  usually  lead  to  legal  complications  which 
need  not  be  followed  out  here. 

What  is  of  interest,  is  the  effect  which  the  procedure  just 
mentioned  has  upon  the  item  of  $4,000  in  the  customer's  ac- 
count. At  first  glance,  and  from  the  side  of  the  contractor,  it 
has  the  appearance  of  a  contingent  asset.  From  the  side  of  the 
customer,  it  appears  to  be  a  contingent  liability.  The  contingency 
in  both  cases  is  that  the  work  may  prove  defective  or  unsatis- 
factory. If  such  a  thing  happens  the  contractor,  it  would  appear, 
will  have  no  claim  upon  the  customer  and  the  customer  will  not 
be  obliged  to  pay  the  contractor. 

It  is  just  here  that  the  fallacy  of  such  reasoning  becomes 
apparent.  In  the  first  place  it  may  be  considered  that  the  con- 
tractor did  have  a  good  claim  upon  the  customer.  He  has  not 
been  able  to  realize  upon  it  on  account  of  being  obliged  to  make 

33 


Principles  of  Accounting 

the  customer  an  allowance  for  defective  work.  Need  a  mer- 
chant who  sells  goods  look  upon  his  accounts  receivable  as  being 
in  part  contingent  assets  because  of  the  fact  that  he  may  be 
obliged  to  make  allowances  to  customers  for  damaged  or  defec- 
tive goods?  It  is  not  probable  that  many  accountants  would 
reason  thus.  Consequently  the  contractor  will  probably  be  seen 
in  the  same  light  as  the  merchant.  The  contractor  seems  to  have 
agreed  for  a  certain  price,  to  deliver  certain  "  goods "  in  the 
form  of  a  building.  If  the  building  is  not  satisfactory  he  allows 
the  customer  to  make  it  so  at  his  (the  contractor's)  expense. 

The  customer,  on  the  other  hand,  is  relieved  from  making  the 
final  payment  to  the  contractor  and  thus  would  appear  to  escape 
the  liability.  He  is  obliged,  however,  if  the  defect  is  to  be  cor- 
rected, to  pay  some  one  other  than  the  contractor.  This  has  no 
effect  on  the  liability.  A  liability,  it  must  be  remembered,  is  not 
determined  by  determining  who  the  creditor  is.  The  fact  that 
the  customer  has  to  pay  some  one  to  do  the  work  would  seem 
to  remove  any  trace  of  a  contingency  and  stamp  the  amount  in 
question  as  a  definite  liability. 

The  various  methods  of  handling  contracts  on  the  books  of 
the  contractor  may  be  generally  represented  by  eight  typical 
cases.  To  show  the  accounts  affected  and  the  manner  in  which 
they  are  affected,  in  the  different  cases,  is  the  object  of  the  fol- 
lowing journal  entries  and  ledger  accounts.  The  figures  used  in 
each  case  are: 

Contract  price  $40,000 

Amount  retained  4,000  (or  10  per  cent) 

Cost  30,000 

Estimates 
(i)  $12,000 

(2)  8,000 

(3)  14,000 

(4)  6,000 

First  Case,  based  on  the  assumption  that 

(a)  Contract  price  is  entered  in  books  when  contract  is 

signed. 
{b)  Income  (or  earning)  from  contract  is  not  taken  up 

until  contract  is  completed. 

34 


Buildings 

Upon  signing  the  contract 
Customer 
To  Income  from  Contracts 
Upon  payment  of  estimates 
Cash 
To  Customer 
For  cost  of  contract 
Cost  of  Contract 
To  Accounts  Payable  (or  cash) 
Upon  completion  of  contract 
Income  from  Contracts 
To  Reserve  for  Defective  Work 

The  ledger  accounts  will  appear  as  follows 


Customer 


Income  from  Contracts 


$40,000 

36,000 

30,000 

4,000 

Cost  of  Contract 


$40,000     $36,000 


Cash 


$4,000     $40,000 


Accounts  Payable 


$30,000 


Reserve  for  Defective 
Work 


$36,000 


$30,000 


$4,000 


Second  Case,  based  on  the  assumption  that 

(a)  Contract  price  is  entered  in  books  when  contract  is 

signed. 

(b)  Income  from  contracts  is  applied  to  period  in  which 

earned. 

(c)  Books  close  when  contract  is  half  completed. 
Upon  signing  the  contract 

Customer 

To  Income  from  Contracts  $40,000 

Upon  payment  of  two  estimates 
Cash 
To  Customer  18,000 

For  Cost  of  Contract 
Cost  of  Contract 
To  Accounts  Payable  (or  cash)  15,000 


35 


Principles  of  Accounting 

Upon  closing  the  books 

Income  from  Contracts  $22,000 

To  Reserve  for  Uncompleted  Contracts  $20,000 
Reserve  for  Defective  Work  2,000 

The  ledger  accounts  will  appear  as  follows: 

Customer  Income  from  Contracts         Cash  Cost  of  Contracts 


$40,000 


$18,000   $22,000 


$40,000   $18,000 


$15,000 


Accounts  Payable 


Reserve  for  Uncompleted 

Contracts 


Reserve  for  Defective 
Work 


$15,000 


$20,000 


$2,000 


Third  Case,  based  on  the  assumption  that 

(a)  Contract  price  is  not  entered  in  books  when  contract 

is  signed. 

(b)  Estimates  are  entered  broad  as  rendered. 

(c)  Income  from  contracts  is  not  taken  up  until  contract 

is  completed. 
Upon  signing  the  contract 

No  entry  in  general  books 
Upon  rendering  estimates  i  to  4 

Customer  (i)  $12,000 

To  Income  from  Contracts  $10,800 

Reserve  for  Defective  Work  1,200 

Customer  (2)   (3)   (4)  28,000 

To  Income  from  Contracts  25,200 

Reserve  for  Defective  Work  2,800 

Upon  payment  of  estimates 
Cash 

To  Customer  36,000 

For  Cost  of  Contract 
Cost  of  Contract 
To  Accounts  Payable  (or  cash)  30,000 

Upon  closing  the  books — no  entry  necessary 


36 


Buildings 

The  ledger 

accounts : 

Customer 

Income  from  Contracts 

Reserve  for  Defec- 
tive Work 

$12,000 
28,000 

$36,000 

$10,800 
25,200 

$1,200 
2,800 

Cash 

Cost  of  Contract 

Accounts  Payable 

$36,000 

$30,000 

$30,000 

Fourth  Case,  based  on  the  assumption  that 

(a)  Contract  price  is  not  entered  in  books  when  contract 

is  signed. 
(&)  Estimates  are  entered  broad  as  rendered. 

(c)  Income  from  contracts  is  applied  to  period  in  which 

earned. 

(d)  Books  close  when  contract  is  half  completed. 
Upon  signing  the  contract — ^no  entry 

Upon  rendering  estimates  i  and  2 

(i)  Customer  $12,000 

To  Income  from  Contracts  $10,800 

Reserve  for  Defective  Work      1,200 
(2)  Customer  8,000 

To  Income  from  Contracts 

Reserve  for  Defective  Work 
Upon  payment  of  estimates 
Cash 

To  Customer 
For  Cost  of  Contract 
Cost  of  Contract 

To  Accounts  Payable  (or  cash) 

Upon  closing  the  books — no  entry 
37 


7,200 
800 


18,000 


15*000 


Principles  of  Accounting 


The  ledger  accounts: 

Customer  Income  from  Contracts 


Reserve  for  Defective 
Work 


$12,000 

8,000 


$18,000 


Cash 


$10,800 
7,200 


Cost  of  Contract 


$1,200 
800 


Accounts  Payable 


$18,000 


$15,000 


$15,000 


Fifth  Case,  based  on  the  assumption  that 

(a)  Contract  price  is  not  entered  in  books  when  contract 

is  signed. 

(b)  Estimates  are  entered  net  as  rendered. 

(c)  Income  from  contracts  is  not  taken  up  until  contract 

is  completed. 
Upon  signing  the  contract — no  entry 
Upon  rendering  estimates  i  to  4 
Customer 

To  Income  from  Contracts  $36,000 

(i)  $10,800 

(2)  7,200 

(3)  12,600 

(4)  5400 
Upon  payment  of  estimates 

Cash 
To  Customer  36,000 

For  Cost  of  Contract 
Cost  of  Contract 

To  Accounts  Payable  (or  cash)  30,000 

Upon  closing  the  books 
Customer 

To  Reserve  for  Defective  Work  4,000 

The  ledger  accounts: 
Customer  Income  from  Contracts  Reserve  ^r  Defective 


$36,000 
4,000 


$36,000 


$36,000 


$4,000 


38 


Cash 


Buildings 
Cost  of  Contracts 


Accounts  Payable 


$36,000 


$30,000 


$30,000 


Sixth  Case,  based  on  the  assumption  that 

(a)  Contract  price  is  not  entered  in  books  when  contract 

is  signed. 

(b)  Estimates  are  entered  net  as  rendered. 

(c)  Income  from  contract  is  applied  to  period  in  which 

earned. 

(d)  Books  close  when  contract  is  half  completed. 
Upon  signing  the  contract — no  entry 

Upon  rendering  estimates  i  and  2 
(i)  Customer 

To  Income  from  Contracts  $10,800 

(2)  Customer 

To  Income  from  Contracts  7,200 

Upon  payment  of  estimates 
Cash 
To  Customer  1 8,000 

For  Cost  of  Contract 
Cost  of  Contract 
To  Accounts  Payable  (or  cash)  15,000 

Upon  closing  the  books 
Customer 
To  Reserve  for  Defective  Work  2,000 


The  ledger  accounts: 

Customer  Income  from  Contracts 


$10,800 
7,200 
2,000 


$18,000 


Cash 


$10,800 
7,200 


Cost  of  Contract 


$18,000 


$15,000 


Reserve  for  Defective 
Work 


$2,000 


Accounts  Payable 


$15,000 


39 


Principles  of  Accounting 


Seventh  Case,  based  on  the  assumption  that 

(a)  Contract  price  is  not  entered  in  books  when  contract 

is  signed. 

(b)  Estimates  are  not  entered  as  rendered. 

(c)  First  entry  is  made  when  cash  is  received. 

(d)  Income  from  contracts  is  not  taken  up  until  con- 

tract is  completed. 
Upon  signing  the  contract — no  entry 
Upon  rendering  estimates — no  entry 
Upon  payment  of  estimates 
Cash 

To  Customer  $36,000 

For  Cost  of  Contract 
Cost  of  Contract 

To  Accounts  Payable  (or  cash)  30,000 

Upon  closing  the  books 

Customer  $40,000 

To  Income  from  Contracts  36,000 

/  Reserve  for  Defective  Work  4,000 


The  ledger  accounts: 

Customer  Income  from  Contracts 


Reserve  for  Defective 
Work 


$40,000     136,000 


$36,000 


$4,000 


Cash 


Cost  of  Contract 


$36,000 


$30,000 


Accounts  Payable 


$30,000 


Eighth  Case,  based  on  the  assumption  that 

(a)  Contract  price  is  not  entered  in  books  when  contract 

is  signed. 

(b)  Estimates  are  not  entered  as  rendered. 

(c)  First  entry  is  made  when  cash  is.  received. 

(d)  Income  from  contracts  is  applied  in  the  period  in 

which  earned. 


40 


Buildings 


(e)  Books  close  when  contract  is  half  completed. 
Upon  signing  the  contract — no  entry 
Upon  rendering  estimates — no  entry 
Upon  payment  of  estimates  i  and  2 

(i)  Cash 

To  Customer  $10,800 

(2)  Cash 

To  Customer  7,200 

For  Cost  of  Contract 
Cost  of  Contract 
To  Accounts  Payable  (or  cash)  15,000 

Upon  closing  the  books 

Customer  $20,000 

To  Income  from  Contracts  18,000 

Reserve  for  Defective  Work  2,000 


The  ledger  accounts : 

Customer  Income  from  Contracts 


Reserve  for  Defective 
Work 


$20,000 


$10,800 
7,200 


Cash 


$18,000 


Cost  of  Contract 


$2,000 


Accounts  Payable 


$10,800 
7,200 


$15,000 


$15,000 


Before  leaving  the  subject,  a  word  or  two  should  be  offered 
in  explanation  of  the  foregoing  cases. 

When  the  statement  has  been  made  that  no  entry  has  been 
made  in  the  books  it  is  understood  to  mean  the  general  books. 
Few  cases  could  probably  be  found  in  which  a  memorandum  of 
contracts  in  some  subsidiary  book  of  account  or  record  are  not 
made.  Statistics  are  not  available  to  show  the  preference  with 
regard  to  the  various  methods  shown. 

It  will  be  noted  that  the  ledger  accounts  have  been  allowed 
to  remain  unclosed  to  profit  and  loss.  It  should  be  understood 
that  no  closing  entries  have  been  made  except  such  as  are  neces- 
sary to  make  the  accounts  affected  by  the  contracts  show  the  true 
facts  in  the  different  cases.     If  the  closing  entries  were  con- 


41 


Principles  of  Accounting 

tinued,  such  accounts  as  cost  of  contracts  and  income  from  con- 
tracts would  be  closed  out  to  profit  and  loss  to  show  either  of 
these  two  results,  as  the  case  might  be.  An  intermediate  account, 
called  a  contract  account,  is  sometimes  used  for  this  purpose. 
Into  it  are  closed  the  cost  of  contracts  and  income  from  con- 
tracts, and  after  the  profit  or  loss  on  contracts  is  thus  deter- 
mined it  is  closed  out  to  profit  and  loss.  It  may  also  be  men- 
tioned that  this  contract  account  is  frequently  used  in  practice, 
not  as  an  intermediary  in  closing,  but  to  take  the  place  of  the 
detail  accounts  just  mentioned,  namely,  cost  of  contracts  and 
income  from  contracts.  It  is  true  that  such  an  account  will  show 
the  profit  or  loss  on  contracts,  but  it  has  too  great  a  resemblance 
to  the  merchandise  and  other  mixed  accounts  to  meet  with 
favor  in  the  best  modern  practice. 

In  the  eight  typical  >  cases  previously  illustrated  by  journal 
entries  and  ledger  accounts  the  reserve  for  defective  work  was 
left  open.  The  question  which  might  naturally  arise  is,  what 
is  to  become  of  the  reserve?  The  disposition  of  it  will  depend 
upon  whether  the  work  withstands  the  test  of  a  reasonable  length 
of  time.  If  it  does,  the  reserve  will  have  served  its  purpose. 
The  amount  reserved  by  the  customer  will  be  due.  The  reserve 
may  be  closed  into  the  income  from  contracts  account  or  to 
profit  and  loss,  depending  upon  the  circumstances. 

If  the  work  becomes  defective,  one  of  two  things  may  occur; 
either  the  customer  will  cause  the  contractor  to  cure  the  defect 
or  if  the  contractor  refuses  he  will  proceed  to  do  it  himself.  If 
the  contractor  is  obliged  to  do  further  work,  while  he  will  still 
be  able  to  collect  from  the  customer  the  amount  withheld,  the 
additional  work  will  have  the  effect  of  increasing  the  cost  and 
consequently  reducing  the  profit.  Reducing  the  profit  means 
reducing  the  reserve  if  the  cost  of  the  contract  happens  to  have 
been  closed  out  to  profit  and  loss,  so  that  if  such  is  the  case  it 
would  appear  proper  to  charge  the  additional  work  against  the 
reserve. 

Should  the  contractor  refuse  to  make  good  the  defects  and 
the  customer  proceeds  with  such  work,  then  at  time  of  settlement, 
the  customer  would  be  credited  with  the  amount  expended  and 
would  pay  over  the  balance.  Assuming  that  of  $4,000  retained 
by  the  customer,  $2,500  has  been  so  expended,  the  situation 
would  be  described  by  the  following  journal  entries: 

42 


Buildings 

Reserve  for  Defective  Work  $4,ocx) 

To  Customer  $2,5CX) 

Income  from  Contracts  1,500 

(or  profit  and  loss) 
Cash 

To  Customer  1,500 

Applied  Theory  Test  Number  Two 

PART   I 

A  employs  B  to  draw  plans  for  a  building,  paying  him  there- 
for four  per  cent  of  the  cost  of  the  building.  B  furnishes  no 
supervision.  A  buys  from  C  all  material,  amounting  to  $40,cxx)  on 
which  he  has  paid  $35,000.  The  labor  cost  $55,000.  Incidentals, 
permits,  etc.,  $1,153.85  (paid).  Determine  the  cost  of  the  build- 
ing and  express  the  factors  entering  into  the  cost  in  the  form 
of  a  journal  entry  followed  by  full  description. 

PART   II 

The  Spencer  Manufacturing  Company  engaged  Mr.  Archi- 
bald Russian  as  the  architect  to  draw  plans  and  supervise  the 
construction  of  an  addition  to  its  plant.  The  rate  of  6%  was 
to  be  charged  for  this  work,  but  it  was  agreed  that  he  should 
design  certain  decorative  work  in  the  private  office  which  was  a 
part  of  the  new  construction.  For  this  work  he  was  to  receive 
fifteen  per  cent.  The  contract  was  let  to  James  Downs  for 
$60,000,  who  rendered  three  estimates  from  time  to  time  in  the 
amounts  of  $15,000,  $25,000,  and  $20,000.  Extra  work  amounted 
to  $2,500.  Ten  per  cent  was  retained  on  the  regular  work,  but 
not  on  the  extra  work.  The  decorative  work  in  the  private  office 
cost  $2,250.  The  work  was  begun  in  May  and  was  two  thirds 
completed  at  June  30,  1908,  when  both  firms  closed  their  books. 
The  extra  work  and  decorative  work  was  completed  at  such 
time.  The  extra  work  had  been  invoiced,  as  had  the  first  two  esti- 
mates. The  decorative  work  was  included  in  the  contract. 
Downs  had  received  pay  for  the  first  estimate.  Both  firms  fol- 
lowed the  practice  of  entering  estimates  broad,  as  rendered. 
Downs  had  expended  $37,500  and  charged  it  to  an  account — 
Spencer  Contract — and  had  figured  $51,000  as  the  cost  to  him 

43 


Principles  of  Accounting 

when  he  made  the  contract.  The  cost  of  the  extra  work  was 
$i,8oo.  Frame  the  entries  necessary  to  show  the  facts  at  June 
30th,  (a)  as  to  the  books  of  the  Spencer  Manufacturing  Co.,  (b) 
as  to  the  books  of  James  Downs. 


PART   III 

After  the  work  was  completed,  some  parts  of  it  proved  de- 
fective. Downs  refused  to  make  the  necessary  corrections  and 
the  company  was  obHged  to  spend  $2,500  in  making  it  right. 
The  balance  of  Downs'  funds  were  paid  over  to  him.  Assuming 
all  bills  of  every  description  to  have  been  paid  by  both  parties, 
frame  the  journal  entries  and  set  up  skeleton  ledger  accounts  to 
show  how  the  work  would  finally  stand  on  the  books  of  the  three 
different  parties  interested  in  the  construction. 

REFERENCES  FOR  COLLATERAL  READING! 

Accounts,  Their  Construction  and  Interpretation,  Cole,  Chap- 
ters VII,  XIII. 

Modern  Accounting,  Hatfield,  Chapter  IV. 

Auditing  Theory  and  Practice,  Montgomery,  page  304. 


44 


CHAPTER   VIII 
BUILDINGS — (continued) 

Land  in  the  last  chapter  was  seen  to  have  an  important 
bearing  upon  the  business  situation  with  respect  to  its  location. 
Buildings  play  an  equally  important  part  with  regard  to  their 
physical  arrangement.  Considerable  attention  has  undoubtedly 
been  given  always  to  the  matter  of  convenience  in  constructing 
or  arranging  a  new  building  or  system  of  buildings.  More  than 
the  usual  attention  is  now  being  paid  to  what  might  be  termed 
the  scientific  arrangement  of  buildings  in  a  manufacturing  plant, 
which  is  in  effect  a  system  of  buildings.  Great  attention  is  given 
to  the  planning  in  order  that  there  may  be  no  lost  motion  in  the 
case  of  production.  The  receiving  department  should  be  easily 
accessible  for  wagon  and  team  deliveries  as  well  as  on  the  rail- 
road siding  if  one  exists.  The  stores  department  should  be  ad- 
jacent to  both  the  receiving  department  and  the  manufacturing 
department  in  which  the  material  is  first  used.  The  idea  thus 
conveyed  should  be  carried  out  in  the  succeeding  stages  of  manu- 
facture, in  such  manner  that  the  finished  goods  will,  with  the 
least  possible  amount  of  lost  motion,  end  in  the  shipping  room. 

New  construction,  and  especially  that  of  new  plants,  which 
rather  than  old  plants  are  usually  best  adapted  to  maximum  pro- 
duction with  a  minimum  of  cost  and  expense,  frequently  involve 
such  large  sums  of  money  that  concerns  are  obliged  to  borrow 
for  construction  purposes.  Such  funds  are  frequently  obtained 
through  the  medium  of  bonds,  the  security  for  which  is  vested 
in  the  newly  constructed  buildings.  It  is  usually  provided  in 
such  bonds  that  the  proceeds  resulting  from  their  sale  are  to  be 
used  only  in  the  construction  for  which  the  funds  are  obtained. 

In  addition  to  the  above  ways  in  which  buildings  may  be  ob- 
tained for  business  purposes,  it  should  of  course  be  mentioned 
that  they  may  be  purchased.  If  adapted  to  the  purposes  of  the 
business  they  may  be  occupied  without  alteration  or  improvement. 
They  may  be  purchased  for  cash  or  on  credit.  In  either  case 
they  may  be  free  or  they  may  carry  a  mortgage.  In  the  pur- 
chase of  buildings  on  which  there  is  a  mortgage  such  mortgage 
may  be  assumed  or  the  buildings  bought  subject  to  the  mort- 

45 


Principles  of  Accounting 

gage,  and  regardless  of  this  the  building  may  be  partially  paid 
for  by  a  purchase  money  mortgage.  After  a  building  or  build- 
ings have  been  acquired  free  from  mortgage  it  may  be  necessary 
to  borrow  money,  giving  the  buildings  as  security. 

Thus  in  the  purchase  of  land  or  buildings,  or  both,  or  in  the 
borrowing  of  money  as  security  for  which  the  building  is  offered 
the  accountant  may  come  in  contact  with  two  classes  of  items 
which  may  affect  the  accounts. 

One  may  be  that  of  commission  paid  to  the  real  estate  broker 
who  brings  about  the  transaction.  The  transaction  itself  may 
consist  in  a  sale  or  a  loan.  In  either  case,  in  New  York  City  at 
least,  the  broker  as  a  rule  receives  a  commission  of  one  per  cent. 
In  the  case  of  a  sale  the  commission  is  usually  paid  by  the  client 
who  retains  the  broker.  In  the  case  of  a  loan  the  commission  is 
usually  paid  by  the  borrower. 

Another  interesting  and  somewhat  involved  situation  occurs 
in  the  "  closing  of  a  title,"  as  it  is  called.  This  is  the  technical 
expression  used  by  real  estate  men  to  describe  the  consummation 
of  the  transaction  involving  the  purchase  of  a  piece  of  property. 
It  is  the  time  when  the  title  of  the  property  is  actually  transferred 
by  the  vendor  to  the  vendee. 

There  are  usually  many  details  which  arise  at  the  time  of  clos- 
ing title  which  may  not  be  overlooked,  such  as  insurance,  taxes, 
interest,  rents,  assessments,  water  rates,  and  the  expense  of  draw- 
ing and  recording  the  mortgage,  as  well  as  the  mortgage  tax  if  a 
mortgage  is  involved. 

The  insurance  premium  is  usually  pro-rated  and  an  amount 
equal  to  the  unexpired  proportion  paid  to  the  seller  by  the  pur- 
chaser. 

The  expenses  in  connection  with  the  mortgage,  such  as  the 
drawing  and  recording  and  the  mortgage  tax,  are  borne  by  the 
purchaser. 

Rents,  and  interest  on  the  mortgage,  will  depend  upon 
whether  they  have  been  collected  or  paid,  in  either  case,  by  the 
seller  or  whether  they  are  to  be  collected  or  paid  by  him. 

Taxes  and  assessments  are  usually  paid  by  seller  if  at  date  of 
closing  they  have  become  a  lien  upon  the  property.  The  same 
is  true  of  water  rates  when  based  upon  the  frontage,  but  where 
measured  by  meter  the  item  is  subject  to  adjustment. 

The    matter    of    rents,    for    example,    would    depend    upon 

46 


Buildings — Continued 

whether  they  were  payable  in  advance  or  at  the  end  of  a  period 
and  whether  or  not  they  have  been  collected  by  the  owner,  or 
seller,  at  the  time  of  closing  title.  If  they  have  been  collected, 
it  is  clear  that  the  purchaser  will  not  receive  them.  If  the  rent 
of  a  certain  store  is  $ioo  per  month  payable  in  advance,  and  the 
property  changes  hands  on  the  fifteenth  of  a  given  month,  then 
at  time  of  closing  title  the  seller  will  have  received  $50  which 
belongs  to  the  purchaser.  This  amount  the  seller  must  give  the 
purchaser  credit  for  in  closing. 

To  bring  out  the  various  points  which  arise  in  the  purchase 
of  property,  and  to  confront  the  accountant  with  a  situation  such 
as  he  is  liable  to  meet,  is  the  purpose  of  the  following  tests : 

Applied  Theory  Test  Number  Three 

The  Mellenette  Realty  Company  after  negotiations  with 
James  Stafford  has  entered  into  a  contract  to  purchase  from 
him  a  four-story  building  occupied  as  a  factory.  The  contract 
price  is  $80,000.  The  title  is  to  close  December  15th.  There  was 
paid,  by  the  Company,  as  earnest  money,  $10,000.  The  prop- 
erty is  to  be  taken  subject  to  a  mortgage  of  $15,000  which  bears 
interest  at  six  per  cent  and  which  was  last  paid  to  include  June 
30th.  The  building  is  insured.  The  last  premium  paid  was 
$360,  which  covered  the  property  for  the  year  beginning  January 
1st.  There  are  two  firms  occupying  the  building.  One  pays 
$600  per  month  in  advance.  The  other  $100  per  month,  at  the 
end  of  the  month.  The  liens  against  the  property  are:  taxes, 
$1,320;  paving,  $400;  water  rents,  $250. 

Assuming  that  at  the  time  of  closing,  there  was  to  be  a  pur- 
chase money  mortgage  of  $3,000  given,  the  rents  had  been  paid 
according  to  agreement  and  that  the  expense  of  drawing  the 
mortgage  was  $10,  recording  $3,  and  the  mortgage  tax  $15,  pre- 
pare the  closing  statement. 

In  connection  with  the  closing  of  title  mention  may  be  made  of 
the  title  insurance  policy  which  the  purchaser  usually  provides 
himself  with  before  closing. 

The  purchaser  is  presumed  to  know  that  the  title  is  free  and 
clear  of  encumbrances.  To  be  sure  of  this  fact  it  is  necessary 
that  the  public  record  be  searched.  Few  laymen  are  qualified 
for  this  work.    A  lawyer  may  furnish  a  report  on  a  title  and 

47 


Principles  of  Accounting 

still  the  purchaser  has  nothing  more  than  the  lawyer's  opinion 
that  the  title  is  clear. 

Title  insurance  companies  engage  in  such  business  and  not 
only  render  opinions  in  the  shape  of  reports,  but  back  up  reports 
with  a  guarantee  against  defect  in  the  title.  For  this  service 
a  premium,  payable  but  once,  is  charged.  That  such  companies 
fill  a  long-felt  demand  is  evidenced  by  their  number  and  prosper- 
ous condition. 

REFERENCES  FOR  COLLATERAL  READING: 

Accounts,  Their  Construction  and  Interpretation,  Cole  Chap- 
ters VII,  XIII. 

Modern  Accounting,  Hatfield,  Chapter  IV. 
Auditing  Theory  and  Practice,  Montgomery,  page  304. 


48 


CHAPTER   IX 

BUILDINGS — WHAT   MAY   HAPPEN   TO   THEM 

In  discussing  buildings  with  regard  to  what  may  happen  to 
them,  two  phases  of  the  situation  should  be  covered,  namely, 
what  may  occur  physically,  and,  as  to  the  title. 

Physically  they  are  subject  to  improvement,  betterment,  re- 
pair, renewal,  replacement,  alteration,  depreciation,  assessment, 
and  destruction.  Of  these,  the  questions  of  assessment  for  taxes 
and  of  depreciation  are  of  such  importance  that  they  will  be  dis- 
cussed in  detail  later  on. 

As  to  the  title,  buildings  may  be  affected  by  encroachment, 
encumbrance,  restriction,  non-payment  of  taxes,  and  through 
liens  obtained  by  builders  or  other  judgment  creditors.  The 
courts  will  usually  grant  what  is  known  as  a  builder's  lien  in  cases 
where  a  builder  remains  unpaid  for  material  furnished  in  the 
construction  of  the  building.  Equal  protection  is  afforded  to  the 
laborer  through  what  is  known  as  the  mechanic's  lien. 

The  terms,  improvement,  addition,  alteration,  repair,  renewal, 
and  replacement  are  used  somewhat  promi3CUOusly  in  bookkeep- 
ing and  accounting.  They  should  be  used  with  a  great  deal  of 
care.  Such  care  can  only  be  exercised  by  giving  thought  to  the 
meaning  of  the  various  terms.  The  basis  for  decision  in  each 
case  should  be  one  of  value  rather  than  cost. 

An  improvement  signifies  an  increase  in  value.  Nothing 
should  be  recognized  as  an  improvement  which  does  not  add 
value  to  the  property.  Adding  value  usually  carries  with  it  the 
thought  that  the  earning  power  of  the  property  is  increased,  al- 
though not  necessarily.  It  distinctly  implies  value  added  to  that 
which  previously  existed. 

In  connection  with  improvements,  two  questions  arise. 
First,  is  the  improvement  permanent  in  its  nature?  Second, 
is  the  improvement  temporary  in  its  nature  ?  Both  questions  are 
practically  answered  by  determining  whether  the  property  in- 
volved is  owned  or  rented. 

If  the  property  is  owned,  the  improvement  usually  becomes 
a  permanent  addition,  subject,  like  that  to  which  it  was  added, 

49 


Principles  of  Accounting 

to  destruction  by  time  and  use.  If  the  improvement  is  made  to 
rented  property,  then  the  question  of  permanency,  or  of  the  life 
of  the  added  value,  is  fixed  by  the  terms  of  the  lease. 

Fire  escapes,  for  example,  might  constitute  the  improvement 
in  a  given  case.  If  the  building  were  owned,  there  would  prob- 
ably be  no  doubt  about  the  practice  of  capitalizing  the  improve- 
ment and  subsequently  writing  the  cost  down  along  with  the 
remainder  of  the  building.  If  such  an  improvement  were  made 
to  rented  property,  the  treatment  of  such  an  addition  would  de- 
pend upon  the  terms  of  the  lease.  One  of  two  things  would 
probably  be  true ;  either  the  owner  would  allow  the  tenant  a  cer- 
tain amount  for  the  improvement  at  the  expiration  of  the  lease, 
or  it  would  pass  at  such  time  to  the  owner  of  the  building.  If 
the  former  were  the  case,  and  the  amount,  as  usually  happens, 
could  be  determined  sufficiently  in  advance,  then  there  should  be 
written  off  over  the  period  covered  by  the  lease,  or  the  balance 
of  the  period  of  its  life,  an  amount  equal  to  the  difference  be- 
tween the  original  cost  of  the  improvement  and  the  amount  to  be 
allowed  by  the  owner  of  the  building. 

If  no  allowance  were  to  be  made  by  the  owner  at  the  expira- 
tion of  the  lease,  the  accounting  procedure  would  be  similar, 
except  that  the  amount  to  be  written  off  over  the  number  of 
years  covered  by  the  lease  would  be  the  entire  cost  of  the  im- 
provement, rather  than  the  net  amount,  as  in  the  preceding  case. 

Additions  are  practically  synonymous  with  improvements. 
They  are  subject  to  the  same  qualifications  concerning  owned  and 
rented  property  and  to  similar  treatment  after  determining 
whether  they  are  permanent  or  temporary  in  their  nature. 

Repairs  should  convey  to  the  mind,  restoration  to  the  original 
condition  after  deterioration  or  impairment.  They  seem  to  differ 
from  renewals  and  from  replacements  principally  in  extent. 
They  may  be  termed  minor  renewals.  They  involve  such  work 
as  is  necessary  to  maintain  the  subject  to  which  they  are  applied 
in  its  original  state  of  efficiency,  or  of  appearance. 

The  relation  of  repairs  to  renewals  and  replacements  may 
perhaps  be  seen  more  clearly  by  taking  a  shingle  roof,  for  exam- 
ple. The  roof  loses  its  efficiency  when  it  begins  to  leak.  It  is 
failing  to  perform  the  function  for  which  it  was  partially  in- 
tended, namely,  to  keep  out  the  water.    The  efficiency  of  the 

50 


Buildings — What  May  Happen  to  Them 

roof  may  be  restored  by  patching  the  holes.  This  is  repairing 
the  roof  and  answers  the  purpose  until  the  holes  become  so 
numerous  that  a  renewal  of  the  entire  roof  becomes  advisable. 
It  might  be  said  with  equal  truth  that  the  old  roof  had  been  re- 
placed. 

Thus,  while  the  roof  might  have  been  repaired,  or  renewed 
or  replaced,  no  value  has  been  added  to  the  building  for  the  rea- 
son that  in  either  case,  the  cost  of  the  repair  or  renewal  has 
merely  been  in  connection  with  the  restoration  of  the  roof  to  a 
condition  represented  by  the  original  cost.  The  cost  of  the  re- 
pair or  renewal  becomes  an  expense  and  is  chargeable  to  the  up- 
keep or  maintenance  of  the  building. 

The  general  rule  above  mentioned  is  subject  to  qualification 
in  certain  instances  and  under  certain  conditions.  In  the  case  of 
renewals  or  replacements,  if  the  material  replaced  has  a  salvage 
or  scrap  value,  it  is  usually  considered  proper  to  reduce  the  ex- 
pense  of  the  renewal  by  such  value  and  charge  to  up-keep  or 
maintenance  the  net  amount. 

On  the  other  hand  where  the  material  used  to  replace  the 
old  is  different  in  its  character,  or  of  better  quality,  there  would 
seem  to  be  no  objection  to  charging  a  part  of  the  expense  to 
maintenance  and  capitalizing  the  remainder.  The  division  is 
arrived  at  by  a  comparison  of  values  of  the  two  kinds  of  ma- 
terial and  capitalizing  the  amount  by  which  the  value  of  the  new 
material  exceeds  the  old. 

This  point  is  well  illustrated  by  a  railroad,  which  replaces 
sixty  pound  rail  with  eighty  pound  rail.  Using  one  rail,  as  an 
example,  the  cost  of  the  new  eighty  pound  rail  would  be  divided 
into  two  parts;  one  part,  corresponding  to  three- fourths  of  the 
cost  of  the  eighty  pound  rail,  which  would  be  chargeable  to 
maintenance  and  the  other  part,  corresponding  to  the  remaining 
one-fourth  of  the  eighty  pound  rail  which  would  be  chargeable 
to  cost  of  road. 

Alterations  may  partake  either  of  improvements  or  repairs. 
An  alteration  constitutes  a  change.  Changing  the  doors  of  a 
room  does  not  seem  to  add  any  material  value  to  the  room.  It 
may  render  the  room  better  adapted  to  the  needs  of  the  occu- 
pants. Putting  a  partition  in  a  room  seems  slightly  different  in 
that  it  makes  one  room  do  the  work  of  two.     In  the  first  in- 

51 


Principles  of  Accounting 

stance  the  alteration  would  seem  to  constitute  a  repair,  while  in 
the  second  instance  it  appears  to  partake  rather  of  an  improve- 
ment. The  accounting  procedure  would  in  such  cases  be  gov- 
erned by  the  interpretation  which  was  placed  upon  the  work. 

The  possibility  of  their  being  destroyed  adds  an  interesting 
phase  to  the  discussion  of  buildings.  Earthquakes,  floods,  cy- 
clones and  fires  are  among  the  dangers  at  times  besetting  build- 
ings. Their  destruction  may  be  partial  or  complete.  It  is 
brought  about  more  frequently  by  fire  than  any  other  cause. 
Thus  the  discussion  may  profitably  center  around  destruction  by 
fire  but  the  effect  upon  the  accounting  will  be  the  same  in  any 
case,  except  as  to  the  insurance. 

Ordinarily  the  loss  or  destruction  of  an  asset  means  a  credit 
to  the  asset  account  and  a  charge  to  profit  and  loss.  If  build- 
ings are  not  insured  such  will  be  the  procedure  in  case  they  are 
destroyed.  As  a  rule  buildings  are  probably  not  insured  as  to 
earthquakes,  floods  and  cyclones.  They  are  usually  insured 
against  fire.  Their  partial  or  entire  loss  through  any  of  the  first 
three  named  causes  would  result  in  a  charge  to  profit  and  loss 
in  the  amount  of  the  loss.  When  insured,  as  in  the  case  of  fire, 
the  accounting  depends  upon  the  circumstances.  If  the  building 
is  restored  to  its  original  condition  by  the  insurance  company,  no 
entry  is  necessary.  If  a  cash  settlement  is  made  by  the  insurance 
company  the  situation  is  altered.  The  owner  of  the  building  may 
decide  to  restore  the  old  building  in  the  case  of  an  entire  loss  or 
he  may  decide  not  to  rebuild. 

Where  an  insured  building  is  entirely  destroyed,  the  situation, 
so  far  as  the  owner  is  concerned,  is  that  he  has  converted  his 
building  into  cash  in  an  amount  equal  to  the  loss  fixed  by  the 
insurance  company.  He  has  at  his  disposal  a  cash  fund  out  of 
which  he  may  rebuild.  If  the  amount  is  equal  to  the  book  value 
of  the  building  the  procedure  is  simple;  cash  would  be  debited 
and  the  building  account  would  be  credited.  Following  the 
transactions  historically  in  such  a  case,  it  might  be  advisable  to 
interpose  another  entry.  If  the  payment  of  the  cash  by  the  com- 
pany was  not  concurrent  with  the  notification  of  the  amount  of 
loss  allowed,  then  it  would  be  proper  to  charge  the  company 
with  the  amount  allowed  and  adjust  the  building  account,  clos- 
ing out  the  account  with  the  company  subsequently  when  the  cash 
was  received. 

52 


Buildings — What  May  Happen  to  Them 

The  same  thing  might  happen  in  the  case  of  a  partial  loss. 
In  such  an  event  the  adjustment  of  the  building  account  presents 
greater  difficulties.  Suppose  that  on  a  building  costing  $2^,000 
the  company  on  a  partial  loss  allowed  and  paid  in  cash  $5,000. 
The  general  cash  account  or  a  special  insurance  fund  account 
would  be  debited  and  the  building  account  credited  in  the 
amount  of  $5,000.  While  this  is  the  amount  of  the  loss  as  fixed, 
by  the  company,  it  does  not  necessarily  follow  that  $5,000  will 
repair  the  damage.  If  it  would,  the  proposition  would  be  sim- 
ple. As  the  cash  was  expended  and  the  cash  account  credited 
the  building  account  would  be  charged  and  thus  the  value  re- 
stored to  the  account.  But  supposing  the  cost  of  restoration 
was  $6,000  instead  of  $5,000,  would  the  entire  $6,000  be  charged 
to  the  cost  of  the  building?  It  would  not.  What  really  hap- 
pened was,  that  the  loss  was  underestimated  by  the  insurance 
company  and  that  while  it  allowed  only  $5,000  the  loss  in  reality 
was  $6,000.  The  credit  to  the  building  account  should  have  been 
$6,000,  of  which  $5,000  should  have  been  charged  to  cash  while 
the  $1,000  was  charged  to  profit  and  loss.  Obviously  it  is  im- 
possible to  foresee  such  results  so  that  the  proper  end  is  finally 
attained  in  partial  loss  by  charging  disbursements  from  the  cash 
or  insurance  fund  to  the  building  until  they  have  reached  the 
amount  allowed  by  the  company,  after  which  any  further  pay- 
ments are  charged  to  profit  and  loss. 

As  to  the  disposition  of  buildings  it  may  be  said  that  they 
may  be  disposed  of  by  sale,  or  transfer,  or  demolished.  If  sold, 
such  sale  may  be  for  cash  or  on  credit.  When  on  credit  it  may 
stand  in  an  open  account  or  be  represented  by  a  mortgage. 

Where  buildings  are  erected  on  leased  ground,  the  question 
of  their  value  at  the  termination  of  the  lease  becomes  a  problem. 
While  it  may  be  the  intention,  especially  where  the  buildings  are 
of  an  expensive  and  permanent  character,  that  the  lease  will  be 
renewed  from  time  to  time  for  long  terms  of  years,  eventually 
some  one  will  have  to  face  the  problem. 

The  disposition  of  such  property  is  usually  covered  by  the 
lease,  and  while  perhaps  no  general  rule  of  practice  can  be  stated, 
in  many  cases  the  lease  provides  that  the  buildings  shall  be  ap- 
praised and  that  the  owner  of  the  land  shall  have  the  option  of 
purchase  at  the  appraised  value.  Where  such  is  the  provision 
and  the  owner  of  the  land  fails  to  exercise  his  option,  the  owner 

53 


Principles  of  Accounting 

of  the  building  may  be  under  the  painful  necessity  of  moving  the 
buildings,  or  having  them  demolished. 

Where  it  is  stipulated  that  the  owner  of  the  land  shall  pur- 
chase the  buildings  at  an  agreed  price,  it  is  customary,  if  such 
price  be  lower  than  the  cost,  to  write  down  the  excess  over  the 
period  covered  by  the  lease. 


54 


Buildings — PVhat  May  Happen  to  Them 


Applied  Theory  Test  Number  Four 

PART  I 

The  New  York  Foundry  Company,  located  at  Mt.  Vernon, 
N.  Y.,  on  the  main  line  of  the  N.  Y.,  N.  H.  &  H.  Railroad,  leased 
on  January  i,  1909,  for  a  term  of  five  years  a  plant  well  adapted 
to  its  needs,  except  that  there  was  no  railroad  siding. 

The  Company  expended  $2,000  in  constructing  such  siding 
with  the  understanding  that  at  the  termination  of  occupancy  the 
siding  should  pass  to  the  owners  of  the  property. 

Frame  the  entries  covering  such  a  case. 

Assume  that,  having  proceeded  with  the  accounting  under 
the  theory  that  the  lease  was  to  terminate  at  the  end  of  five  years, 
you  were  informed  near  the  end  of  the  period  that  the  lease  had 
been  renewed  for  five  years,  how  would  the  situation  be  affected  ? 

Assume  that  the  lease  provided  that  the  improvement  was  to 
be  taken  over  by  the  landlord  at  the  expiration  of  the  original 
lease  at  a  valuation  of  $1,200,  payment  therefor  to  be  spread 
over  the  terms  of  the  lease  by  deduction  from  the  rent.  The  rent 
was  $6,000  a  year.  Frame  an  entry  covering  the  transactions  for 
any  given  year. 


55 


Principles  of  Accounting- 


Applied  Theory  Test  Number  Four 

PART  II 

Jennings  &  Company  leased  a  four-story  building  on  Univer- 
sity Place  for  a  term  of  twenty  years,  paying  therefor  an  annual 
rental  of  $12,000.  The  firm  occupied  the  first,  second  and  fourth 
floors,  sub-letting  to  another  tenant  the  third  floor  at  an  annual 
rental  of  $2,400.  During  the  first  year  of  occupancy  Jennings  & 
Company  expended  $20,000  in  alterations  and  fixtures  with  the 
understanding  that  certain  partitions  and  other  fixtures  might  be 
removed  upon  the  expiration  of  the  lease. 

At  the  beginning  of  the  eleventh  year  Jennings  &  Company 
moved  to  a  building  on  Murray  Street,  taking  with  them  fixtures 
valued  at  $4,000  and  renting  the  space  which  they  had  occupied 
in  the  University  Place  building  to  various  tenants  at  annual 
rentals  aggregating  $6,000.  In  order  to  secure  desirable  tenants 
it  was  necessary  to  expend  $2,000  for  alterations  which  it  was 
understood  would  revert  to  the  landlord  upon  expiration  of  the 
lease. 

One  sub-tenant  at  University  Place  whose  occupancy  began 
January  i,  1910,  and  whose  annual  rental  was  $960  paid  his 
monthly  rent  for  December,  1910,  in  advance.  The  remaining 
tenants  did  not  pay  for  December  until  January,  1911.  One  of 
these  latter,  on  a  ten-year  lease  at  $600  per  annum,  for  whom 
alterations  amounting  to  $600  were  made  in  January,  1910, 
agreed  to  pay  for  the  alterations  in  equal  monthly  installments 
extending  over  the  period  covered  by  the  lease. 

Frame  the  entries  covering  the  alterations  to  the  University 
Place  building  for  the  year  19 10  and  show  the  net  income  on  the 
building  for  the  year. 


56 


Buildings — What  May  Happen  to  Them 


Applied  Theory  Test  Number  Four 

PART    III 

The  Bundy  Manufacturing  Company  carried  its  buildings  at 
$75,000.  The  buildings  were  designated  by  the  letters  A-B-C  and 
D.  The  values  were  respectively  $30,000,  $15,000,  $20,000  and 
$10,000.  The  equipment  in  building  A  cost  $3,000;  building  B, 
$7,000;  building  C,  $8,000;  building  D,  $500.  The  plant  was 
insured  for  $100,000. 

On  December  31,  1910,  a  fire  occurred  involving  buildings 
A,  B  and  C.  The  insurance  adjusters  visited  the  scene  of  the 
fire  on  January  2,  191 1,  and  the  insurance  company  subsequently 
offered  the  following  settlement: 

Building  A,  including  equipment $13,000 

Building  B,  including  equipment 18,000 

Building  C,  including  equipment 22,000 

$53,000 

The  insurance  company  offered  to  make  a  cash  settlement  on 
building  A.  On  building  C  it  undertook  to  restore  the  building 
itself.  On  building  B  it  agreed  to  approve  bills  for  restoration 
up  to  the  amount  offered  in  settlement.  The  offers  were  all 
accepted  on  February  5,  1911,  and  the  cash  on  building  A  was 
received  February  6,  1911. 

The  restoration  of  building  A,  including  equipment,  cost 
$12,500.  The  restoration  of  building  B,  including  equipment, 
cost  $22,500,  but  included  certain  improvements  valued  at  $2,500. 

Frame  the  entries  necessary  to  record  the  transactions  his- 
torically. 

REFERENCES  FOR  COLLATERAL  READING  I 

Accounts,  Their  Construction  and  Interpretation,  Cole,  Chap- 
ters VII,  XIII. 

Modern  Accounting,  Hatfield,  Chapter  IV. 

Auditing  Theory  and  Practice,  Montgomery,  page  304. 

57 


CHAPTER    X 

EQUIPMENT 

The  term  equipment  has  been  given  many  different  meanings. 
Used  in  one  sense  it  seems  to  be  merely  an  adjunct  of  machinery 
and  tools  as  indicated  by  the  balance  sheet  caption  frequently  seen 
— "machinery,  tools,  and  other  equipment."  In  other  instances  it 
is  apparently  considered  as  quite  distinct  from  machinery  and 
tools  as  evidenced  by  the  separate  balance  sheet  caption — "equip- 
ment." 

The  term  when  used  in  its  broadest  sense  would  seem  to  in- 
clude everything  except  buildings  proper.  By  buildings  proper 
is  meant  the  bare  structures.  Thus,  equipment  would  seem  to 
include  everything  within  the  plant  walls  or  attached  to  them. 
To  enumerate  the  items  comprised  in  such  a  broad  general  class 
would  be  to  embrace  the  equipment  attached  to  the  building  walls, 
machinery  and  tools,  equipment  used  in  connection  with  machin- 
ery, any  other  equipment  used  in  connection  with  the  manufac- 
turing processes,  office  furniture  and  fixtures,  horses,  wagons, 
harness,  automobiles,  etc. 

To  properly  classify  equipment  is  no  easy  task.  The  task  may 
be  somewhat  simplified,  however,  if  the  term  is  first  understood 
as  covering  everything  in  and  about  a  plant  with  the  exception  of 
land  and  buildings.  The  ideal  plant  would  seem  to  consist  of  a 
manufacturing  department,  a  department  for  the  generation  of 
heat,  light  and  power,  a  stores  department,  a  st^ible  and  an  office. 
All  of  these  departments  are  housed  in  buildings.  All  of  these 
buildings  will  undoubtedly  be  equipped  with  apparatus  essential 
to  the  occupancy  of  the  building  regardless  of  the  purpose  for 
which  each  is  used.  They  will  doubtless  all  be  equipped  with 
what  may  be  termed  technical  appurtenances  which  are  necessary 
adjuncts  to  the  purpose  for  which  each  is  used.  Thus  it  would 
seem  for  the  moment  that  two  broad  general  classes  might  be 
established,  namely,  building  equipment  and  technical  equipment. 
Building  equipment  might  properly,  it  would  seem,  be  allowed  to 
stand  without  further  division.  Technical  equipment  would  seem 
to  require  further  classification  in  accordance  with  the  use  to 
which  it  is  put. 

58 


Equipment 

In  attempting  to  go  into  the  refinements  of  the  classification 
in  the  case  of  technical  equipment  certain  conflicts  which  will 
become  apparent  from  time  to  time  as  this  discussion  proceeds, 
are  bound  to  arise  between  building  equipment  and  technical 
equipment. 

Building  equipment  is  usually  understood  to  mean  the  heating 
system  (steam  pipes,  radiators,  etc.),  the  lighting  system  (includ- 
ing fixtures),  elevators,  the  plumbing  system,  the  water  system, 
with  its  pipes,  hydrants  and  faucets,  the  sprinkler  system,  ven- 
tilating system,  fire  hose  and  extinguishers,  etc. 

Since  the  principal  activities  center  around  the  manufacturing 
department,  such  department  must  needs  occupy  an  important 
place^  in  this  discussion.  In  analyzing  the  technical  equipment  of 
the  manufacturing  department  our  attention  is  directed  primarily 
to  the  machinery  and  tools  used  in  the  process  of  manufacturing. 
We  find  shafting  and  belting,  cranes  and  overhead  trolleys,  inter- 
shop  tracks  and  cars,  racks  and  other  receptacles  for  holding 
tools,  facilities  for  moving  the  product  about,  such  as  wheelbar- 
rows, boxes,  cases,  bins,  etc. ;  we  find  vats,  shovels,  picks,  tongs, 
stools  and  benches  and  chairs  for  operatives.  We  find  certain 
auxiliaries,  such  as  machine  shops,  carpenter  shops,  paint  shops, 
repair  departments ;  we  frequently  find  welfare  accessories  in  the 
form  of  kitchens,  dining  rooms,  and  hospitals.  In  the  manufac- 
turing department  we  also  find  desks  and  other  furniture,  and 
mechanical  devices  in  connection  with  the  recording  of  the 
work,  etc. 

The  power  plant  consists  of  the  engines,  boilers,  generators, 
transformers,  and  is  usually  understood  as  including  the  transmis- 
sion ramifications.  There  will  also  be  found  in  this  part  of  the 
plant,  shovels,  wheelbarrows  and  miscellaneous  tools. 

The  stores  department  will  contain  little  technical  equipment 
except  facilities  for  handling  materials  and  supplies  and  some 
office  furniture  and  equipment. 

The  stable  equipment  will  depend  of  course  upon  its  size 
and  the  character  of  the  conveyances  which  this  department 
comprises.  They  will  undoubtedly  be  equipped  with  an  assort- 
ment of  tools  and  where  automobiles  are  used  with  sundry  spare 
parts.  The  office  will  consist  principally  of  furniture  supple- 
mented by  sundry  mechanical  appliances  and  devices  employed 
in  the  office  work. 

59 


Principles  of  Accounting 

Ftoid  the  above  it  will  be  seen  that  various  classifications  may 
be  evolved.  The  equipment  seems  largely  to  be  connected  with 
the  manufacturing  department.  This  might  also  be  called  the 
operating  department.  It  will  be  further  evident  that  much  of 
the  equipment  is  in  departments  or  divisions  which  are  auxiliaries 
to  the  operating  department;  also  that  throughout  the  various 
departments  furniture  and  appliances  devoted  to  the  recording  of 
the  work  are  found.  In  all  of  the  above,  some  equipment  is 
noticeably  large  and  important,  while  in  other  cases  it  is  small 
and  unimportant.  For  the  purpose  of  classification  of  technical 
equipment  it  would  seem  that  there  were  three  main  divisions, 
namely,  manufacturing  equipment,  stable  equipment,  and  furni- 
ture and  office  equipment.  In  the  first  instance  it  might  be  divided 
into  operating  and  auxiliary  equipment.  Miscellaneous  operating 
equipment  might  be  further  divided  into  major  and  minor. 
Auxiliary  equipment  might  be  also  further  classified  as  major 
and  minor. 

In  the  matter  of  conflicts  the  principal  difficulty  is  found  in 
the  cases  of  the  water  system  and  the  lighting  system.  The  water 
system  with  its  pipes,  hydrants  and  faucets  is  undoubtedly  a  part 
of  the  building  equipment,  yet  in  many  cases  its  principal  service 
will  be  to  supply  water  to  the  operating  department  for  use  in 
the  process  of  manufacture,  so  that  it  will  illustrate  one  of  the 
many  difficulties  which  the  classification  of  equipment  presents. 
It  may  be  true  that  light  is  served  principally  to  the  employees 
engaged  in  work  upon  the  product  so  that  this  point  frequently 
furnishes  opportunity  for  a  discussion.  Conflict  will  frequently 
arise  in  connection  with  the  power  plant.  Its  ramifications  may 
transmit  heat,  light,  or  power  and  the  question  arises  as  to 
whether  the  steam  pipes,  light  wires,  and  tubing,  and  the  shafting 
and  belting,  shall  be  considered  a  part  of  the  major  operating 
equipment.  There  will  be  found  below  a  chart  in  which  classifica- 
tion of  the  above  mentioned  items  of  equipment  as  well  as  some 
others  not  previously  mentioned  is  attempted.  In  presenting  it 
the  author  calls  attention  to  the  fact  that  he  is  not  an  engineer 
and  makes  no  pretensions  at  submitting  a  classification  which 
is  proof  against  criticism.  The  whole  subject  is  so  confused  in 
the  mind  of  the  average  student  that  this  chart  is  intended 
merely  to  give  him  a  broad  general  idea  of  the  contents  of  a 
plant  and  enable  him  to  reason  more  clearly  with  regard  to  the 

60 


Equipment 


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Principles  of  Accounting 

vaiious  phases  of  accounting  work  which  are  related  to  plant 
equipment. 

Equipment  like  buildings  is  subject  to  various  possibilities. 
In  studying  the  subject,  thought  should  be  given  to  it  with  regard 
to  how  it  may  be  acquired,  what  may  happen  to  it  and  how  it 
may  be  disposed  of.  Briefly  stated,  it  may  be  acquired  by  pur- 
chase or  construction.  It  is  subject  to  destruction  either  partially 
or  wholly  by  fire  and  the  other  elements.  It  is  usually  affected 
more  than  buildings  by  depreciation.  It  requires  repair  and 
replacement  frequently.    It  may  be  sold,  demolished  or  discarded. 

There  are  several  phases  of  interest  which  arise  in  connection 
with  equipment.  Among  these  is  the  cost.  In  this  connection 
it  must  first  be  determined  whether  the  equipment  is  purchased 
from  outsiders  or  constructed  by  the  proprietor.  Equipment 
may  be  purchased  on  a  contract  which  provides  for  its  installa- 
tion, or  the  purchase  price  may  cover  merely  the  bare  cost  when 
an  extra  charge  is  made  for  its  installation.  If  constructed  by 
the  proprietor  it  will  contain  all  the  elements  of  cost,  namely, 
material,  labor  and  overhead.  Taking  as  an  example  a  new 
machine  purchased  from  an  outsider  to  be  installed  free  of 
charge,  the  cost  will  be  merely  that  stated  in  the  contract. 
If  the  contract  price  covers  only  the  machine  itself  then  there  is 
a  possibility  that  there  will  be  charges  covering  the  inward 
freight  and  cartage,  foundations  for  the  machine,  and  the  further 
expense  of  installation.  The  cost  in  this  case  would  include  all 
these  charges.  If  the  machine  were  to  be  constructed  by  the 
proprietor,  the  cost  would  include  the  material  of  which  it  was 
composed,  the  labor  incident  to  its  construction,  the  preparation 
of  the  foundation  including  the  material,  the  labor  involved  in  the 
installation  and  a  percentage  of  the  overhead  of  the  proprietary 
concern  while  the  machine  was  in  course  of  construction. 

The  division  of  equipment  known  as  machinery  and  tools  is 
frequently  subdivided  and  sometimes  classified  as  machines, 
machine  tools,  fixed  machinery,  movable  machinery,  hand  tools, 
etc.,  and  is  so  classified  presumably  for  purposes  of  identification 
in  individual  cases  where  the  circumstances  indicate.  In  any 
event,  machinery  should  be  understood  to  include  machine  foun- 
dations and  fixed  appurtenances  of  any  importance.  The  ques- 
tion of  tools  brings  to  mind  certain  instances  wherein  equipment 
may  be  considered  by  some  concerns  as  supplies  rather  than 

62 


Equipment 

equipment.  These  are  cases  of  concerns  which  use  large  numbers 
of  small  tools  which  are  so  quickly  worn  out  that  it  is  not  con- 
sidered advisable  to  capitalize  them.  They  are  looked  upon  as 
supplies  and  are  charged  to  expense  immediately  upon  being 
purchased  or  as  soon  as  issued  for  use.  It  is  rather  difficult  to 
lay  down  any  hard  and  fast  rule  in  cases  of  this  kind  and  the 
treatment  will  depend  largely  upon  the  circumstances  in  each 
individual  case,  such  as  the  policy  of  the  company,  or  the  wishes 
of  the  proprietor.  There  are  two  or  three  checks  which  are 
sometimes  placed  upon  the  tendency  of  employees  to  treat  care- 
lessly such  articles  of  equipment.  In  the  case  of  small  tools  which 
wear  out  quickly  the  life  of  the  tool  is  determined  and  the  issue 
placed  upon  a  standard  basis.  They  are  sometimes  charged  to 
the  individuals  who  are  obliged  to  present  the  worn  out  tools 
before  receiving  new  ones.  They  are  sometimes  accounted  for 
by  inventories.  In  this  case  instead  of  being  charged  immediately 
to  expense  at  time  of  purchase  they  are  charged  to  a  purchase 
account  and  the  amount  to  be  charged  to  expense  for  the  period 
is  determined  by  taking  an  inventory  at  the  end  of  the  period, 
placing  upon  it  a  value  and  deducting  it  from  the  cost  of  the 
tools  purchased.  In  one  concern  where  scientific  management  is 
in  operation  each  employee  is  furnished  with  a  supply  of  small 
metal  checks  bearing  his  number.  The  supply  of  tools  in  the 
tool  room  being  systematically  arranged,  the  man  in  charge  of 
the  tool  room  upon  receipt  from  any  given  operative  of  a  certain 
number  of  checks,  issues  the  tools  required  and  substitutes  in 
place  of  the  tools  the  various  checks  which  he  has  received.  Thus 
he  is  enabled  to  tell  at  a  glance  the  employee  to  whom  each  tool 
is  issued.  The  writer  was  interested  to  know  how  the  bonus 
system  which  was  in  use  in  the  plant  affected  the  man  who  had 
charge  of  the  tools  and  upon  inquiry  learned  that  it  was  his  duty 
to  be  in  his  place  during  certain  designated  hours,  to  see  that 
all  the  tools  were  clean,  sharp  and  in  their  proper  places.  This 
was  the  task  imposed  upon  this  particular  individual.  His  work 
was  inspected  periodically  and  if  he  had  complied  with  all  the 
requirements  of  his  task  he  received  an  efficiency  bonus. 

The  accounts  for  equipment  will  depend  largely  upon  the 
peculiar  circumstances  existing  in  each  case.  The  classification 
in  the  general  ledger  will  depend  upon  the  captions  which  are 
required  for  balance  sheet  purposes.    One  concern  may  be  satis- 

63 


Principles  of  Accounting 

fied  with  an  account  called  equipment  to  which  will  be  charged 
machinery  of  every  description  such  as  building  equipment, 
machinery  and  tools,  other  operating  and  auxiliary  manufacturing 
equipment,  power  plant,  horses,  wagons,  harness,  automobiles, 
office  furniture,  etc.  In  other  concerns  separate  accounts  may 
be  kept  for  these  different  classes  of  equipment,  consolidating 
them  in  various  combinations  in  the  balance  sheet.  The  accounts 
may  also  be  kept  separate  at  times  for  the  purpK>se  of  determining 
the  separate  cost  of  some  particular  class  of  equipment  or  for 
controlling  underlying  records  containing  the  details.  It  should 
be  also  borne  in  mind  that  in  some  instances  the  accounts  on  the 
general  ledger  will  be  kept  with  the  various  buildings  in  order 
to  show  in  connection  therewith  the  cost  of  the  respective  build- 
ings, including  their  equipment.  Detailed  records  of  equipment 
are  sometimes  kept  for  the  purpose  of  classifying  it  for  depre- 
ciation purposes.  In  such  cases  the  equipment  is  classified  in  ac- 
cordance with  its  life.  The  matter  of  depreciation  of  equipment 
will  be  discussed  under  that  general  topic  later  on. 

REFERENCES  FOR  COLLATERAL  READING! 

Science  of  Accounts,  Bentley,  pages  151- 156,  191 -194,  196- 
197. 


64 


CHAPTER   XI 

INVESTMENTS 

Every  business  organization  must  be  assumed  to  have  some 
specific  object  in  engaging  in  business.  It  is  true  of  course  that 
the  object  of  all  business  organizations  is  profit.  This,  how- 
ever, is  not  sufficiently  specific.  Each  organization  is  engaged 
in  some  particular  line  of  business  for  profit.  For  such  an  under- 
taking, capital  is  made  available  and  the  assumption  is  that  any 
given  concern  will  upon  organizing  supply  itself  with  such  an 
amount  of  capital  as  is  adequate  to  carry  on  the  business  in 
question.  Such  capital  will  be  in  the  form  of  assets  which  are 
required  for  the  purposes  of  the  business.  For  example  a  con- 
cern may  invest  in  land  upon  which  to  construct  a  building;  it 
may  subsequently  construct  the  building  and  equip  it  with  the 
necessary  facilities  for  transacting  the  business.  A  part  of  the 
capital  may  be  in  the  form  of  cash  and  after  a  period  of  opera- 
tions some  of  the  capital  will  usually  be  in  the  form  of  accounts 
and  notes  receivable.  Whether  engaged  merely  in  trading  or  in 
manufacturing  and  selling,  some  capital  will  be  in  the  form  of 
materials  and  supplies  or  merchandise  either  partially  or  wholly 
completed  and  ready  for  sale. 

In  the  ideal  case  the  proportion  of  capital  invested  in  these 
various  assets  would  be  distributed  proportionately  to  the  need 
of  the  business.  Money  will  not  be  tied  up  in  land  or  buildings 
to  such  an  extent  that  there  is  no  cash  available  for  liquidating 
current  liabilities.  A  concern  will  not  overstock  itself  in  the 
matter  of  merchandise  to  such  an  extent  that  it  is  embarrassed  for 
cash  with  which  to  meet  its  pay  rolls.  If  profits  result  from  the 
transaction  of  business  they  will  presumably  be  converted  into 
cash  and  paid  out  in  the  form  of  dividends,  thereby  reducing  the 
surplus. 

It  sometimes  happens  that  a  concern  accumulates  or  acquires 
profits  which  are  greater  than  the  dividends  necessary  to  allow  a 
fair  return  on  the  invested  capital.  Such  undivided  profits  con- 
stitute a  surplus.  The  cash  may  increase  to  such  an  extent  that 
there  is  more  on  hand  than  that  required  for  current  purposes 

6s 


Principles  of  Accounting 

and  dividends.  It  may  then  be  converted  into  various  forms  of 
assets  known  as  investments.  Such  a  class  comprises  stocks  and 
bonds,  bonds  and  mortgages  and  land  or  buildings  not  required 
in  the  conduct  of  the  business.  They  may  be  income  producing, 
but  such  income  is  not  the  result  of  operations  incident  to  the 
principal  business  of  the  organization.  It  is  to  be  considered  as 
secondary  income  or  income  from  sources  other  than  operations. 
The  income  may  take  the  form  of  interest,  dividends,  or  rent. 

Such  items  may  be  represented  on  the  general  ledger  by  one 
account  for  investments.  However,  the  accounts  will  usually  be 
such  as  to  show  the  classification  of  investments  if  they  are  nu- 
merous. By  this  is  meant  that  ordinarily  if  there  were  securities, 
bonds  and  mortgages  and  real  estate,  there  would  be  separate 
accounts  for  each  of  the  above  mentioned  class  on  the  general 
ledger.  Frequently,  especially  in  large  concerns  such  investments 
become  sufficiently  numerous  to  warrant  subsidiary  records,  sup- 
porting the  controlling  account,  in  which  the  details  of  the  invest- 
ments are  recorded.  It  is  especially  desirable  that  such  books 
should  provide  for  all  the  information  pertaining  to  the  assets. 

Bonds  call  for  the  payment  of  a  fixed  amount  of  money  at  a 
given  time.  They  may  be  purchased  at  par,  above  par  when  they 
are  said  to  be  bought  at  a  premium,  or  below  par,  when  they  are 
said  to  be  bought  at  a  discount.  The  face  of  the  bond  is  payable 
with  interest  at  a  certain  rate  per  cent.  The  interest  although 
calculated  annually  may  be  payable  semi-annually  or  quarterly  on 
specified  dates.  Thus  there  arises  the  question  of  the  accrual  of 
the  interest.  There  is  also  the  no  less  important  question  of  what 
is  to  be  done  with  the  premium,  in  case  the  bonds  were  purchased 
or  acquired  at  a  figure  above  par,  or  what  to  do  with  the  discount 
if  they  were  purchased  or  acquired  below  par. 

A  bond  for  $i,ooo,  payable  20  years  hence,  if  purchased  at 
120  will  only  produce  at  maturity  $1,000.  The  premium  of  $200 
will  be  lost.  On  the  other  hand  the  same  bond  purchased  at  80 
will  produce  at  maturity  $1,000  and  there  will  be  a  gain  of  $200. 
In  the  case  of  the  bond  purchased  at  a  premium,  if  no  steps  are 
taken  to  prevent,  upon  maturity  $200  will  be  charged  to  profit 
and  loss.  In  the  opposite  case  $200  will  be  credited  to  profit  and 
loss.  The  best  practice  in  both  these  instances  dictates  spreading 
either  the  premium  or  discount  over  the  remaining  life  of  the 

66 


Investments 

bond.  These  processes  are  known  as  amortization  in  the  case  o't 
premium  and  accumulation  in  the  case  of  discount. 

The  principles  involved  in  amortization  and  accumulation  are 
well  illustrated  as  applied  in  estate  accounting  to  a  life-tenant 
and  a  remainder-man.  The  life-tenant  is  the  party  who  enjoys 
the  benefit  of  the  income  of  the  estate  during  life,  after  which 
time  the  principal  passes  to  the  so-called  remainder-man.  The 
illustration  which  follows  is  purposely  freed  from  any  element  of 
compound  interest,  such  as  attends  the  scientific  evaluation  of 
bonds  and  division  of  interest,  in  order  that  the  principles  may  be 
the  more  easily  understood. 

A  bond  the  par  value  of  which  is  $i,ooo  is  appraised  on  Janu- 
ary I,  1910,  at  $i,2(X).  The  bond  bears  interest  at  4%  per  annum 
and  matures  January  i,  1930.  Under  the  terms  of  the  will  the 
bond  is  bequeathed  to  A,  but  the  income  is  to  be  enjoyed  by  B 
during  his  life.  B  is  the  life-tenant  and  A  is  the  remainder-man. 
A  has  received  a  bequest  of  $1,200. 

If  B  receives  the  annual  interest  of  $40  he  will  during  the 
period  of  twenty  years  have  collected  $800.  Upon  the  maturity 
of  the  bond  at  the  expiration  of  twenty  years  there  will  be  no 
further  income  and  the  proceeds  of  the  bond  ($1,000)  would 
presumably  be  re-invested  if  B  were  still  alive.  It  will  be  noted 
that  there  has  been  a  loss  of  $200,  all  of  which  under  the  circum- 
stances A  would  have  to  bear.  In  other  words,  the  principal  of 
the  estate  has  been  decreased  $200.  This  occurs  because  no  pro- 
vision has  been  made  to  amortize  the  premium,  which  was 
included  in  the  appraisal.  B  has  apparently  been  receiving  more 
interest  than  he  should  have  received. 

The  facts  are  that  B  has  received  annually  more  than  he 
should  have  received.  Provision  should  have  been  made  for  the 
loss  of  premium  at  maturity.  The  premium  of  $200  should  have 
been  provided  for  by  annual  amortization  extending  over  the 
period  of  ten  years.  Ten  dollars  ($10.00)  should  have  been,  de- 
ducted from  the  interest  paid  to  B  every  year,  and  instead  of 
receiving  $40.00  each  time  he  should  have  received  only  $30.00. 
Thus  during  the  twenty  years  $200  would  have  accumulated  to 
make  good  the  loss  of  premium  upon  maturity  of  the  bond. 

To  make  the  accounting  procedure  clear  the  following  entries 
and  skeleton  ledger  accounts  may  serve: 

67 


Principles  of  Accounting 

1910 

January  i.     Bonds $1,200 

To  Principal $1,200 

Cash $800 

To  Reserve  for  Amortization $200 

Income 600 

(covering  the  period  of  20  years) 

Income ~    $600 

To  Cash $600 

(for  income  paid  to  B) 

1930 

January  i.     Cash $1,000 

Reserve  for  Amortization 200 

To  Bonds $1,200 

(upon  maturity  of  bonds) 


Bonds 


$1,200 


$1,200 


Cash 


Principal 


$  800 
1,000 

$600 

$1,800 

$600 

$1,200 

$1,200 


Reserve  for  Amortization 


Income 


$200 


$200 


$600     $600 


These  accounts,  it  will  be  seen,  show  that  the  principal  of  the 
estate  has  been  maintained  at  $1,200,  notwithstanding  the  fact 
that  the  assets  have  been  converted  from  bonds  into  cash. 

Accumulation  is  the  gradual  increase  of  investment  principal 
through  the  addition  at  each  interest  period  of  a  part  of  the  dis- 
count. Such  procedure  brings  the  bond  to  par  at  maturity. 
Thus,  on  a  yearly  basis,  in  the  case  of  a  6%  bond  yielding  6^%, 
$60.00  would  be  charged  to  accrued  interest;  $5.00  to  invest- 
ment principal ;  and  $65.00  would  be  credited  to  income.  Since 
discount  increases  the  yield,  it  Is  generally  understood  that  the 
life-tenant  of  an  estate  derives  the  benefit  from  the  discount. 

The  application  of  the  principles  to  mercantile  or  other  or- 
ganizations has  the  effect  of  measuring  through  amortization  and 

68 


Investments 

accumulation  the  exact  amount  on  interest  bearing  securities  like 
bonds  which  can  be  taken  into  income.  The  scientific  method  of 
calculation  takes  into  consideration  the  compound  interest  but  as 
this  is  a  matter  of  mathematics  which  tends  to  cloud  the  elucida- 
tion of  principles  and  tables  are  available  for  the  purpose  of  deter- 
mining the  yield  of  bonds  it  will  not  be  discussed  here. 

In  considering  the  matter  of  accrued  interest  it  might  be 
assumed  that  the  interest  on  a  bond  of  $i,cxx)  amounted  to  $60.00 
and  was  payable  semi-annually  on  July  ist  and  January  ist. 
Under  these  circumstances  in  closing  the  books  for  the  quarter 
ended  March  31st  it  would  be  necessary  to  take  into  consideration 
the  accrued  interest  of  three  months,  or  $15.  To  carry  the 
illustration  a  step  further  in  connection  with  the  purchase  of  a 
bond  and  assuming  it  to  have  been  purchased  on  February  28th  at 
par,  the  purchaser  would  pay  to  the  seller  $1,010,  representing  the 
face  value  of  the  bond  and  the  accrued  interest.  The  seller  has 
transferred  to  the  buyer,  having  been  paid  therefor,  the  right  to 
collect  the  interest  on  the  bond  from  the  beginning  of  the  year 
and  when  the  buyer  receives  the  interest  for  the  first  six  months 
he  will  receive  $60.00  and  not  $50.00. 

Taking  into  consideration  all  of  the  above  facts,  it  appears 
then  that  the  records  for  bonds  should  be  rather  elaborate  and 
provide  for  many  possibilities.  Thus  such  a  record  should  show 
the  date  of  the  bond,  the  par,  the  purchase  price,  the  accrued 
interest,  the  rate  of  interest,  the  dates  of  payment  of  interest,  the 
date  of  maturity  of  the  bond,  the  accumulations  of  discount,  the 
amortization  of  premium,  the  sale  of  bonds  with  the  amount  of 
par  sold,  the  sale  price  and  the  accrued  interest  at  time  of  sale. 
Such  possibilities  are  provided  for  usually  by  columnar  ledgers, 
having  appropriate  headings  for  the  columns. 

Stocks  differ  from  bonds  in  that  instead  of  being  promises  to 
pay  a  certain  sum  of  money  at  a  certain  stated  time,  they  are 
evidences  of  share  ownership  in  the  net  assets  of  some  corpora- 
tion. The  income  differs  from  bonds  in  that  it  cannot  be  accrued 
like  interest.  The  income  on  stocks  is  in  the  shape  of  dividends 
whereby  profits  are  distributed,  and  become  available  only  by  an 
act  of  the  directors  of  the  corporation  declaring  such  a  distribu- 
tion of  profits  and  such  a  dividend  payable.  Dividends  may  be 
taken  up  as  income  only  after  having  been  declared.  A  concern 
owning  certain  shares  of  stock  in  the  Pennsylvania  Railroad 

69 


Principles  of  Accounting 

Company  where  dividends  continued  uninterrupted  at  a  fixed 
rate  over  a  period  of  years  would  not  be  justified  if  upon  closing 
the  books  at  March  31st  the  quarterly  dividend  on  Pennsylvania 
stock  had  not  been  declared.  If,  however,  such  a  dividend  were 
declared  on  March  27th,  payable  on  April  15th  to  stockholders  of 
record  on  March  31st,  then  a  concern  owning  stock  in  the  Penn- 
sylvania Railroad  might  properly  take  such  a  dividend  into  income 
even  though  it  had  not  yet  been  actually  received.  The  books 
in  such  case  should  provide  adequately  for  all  details  concerning 
stock  showing  the  date  of  purchase,  the  par  purchased,  the  market 
price  whether  with  or  without  dividends,  the  date  of  sale,  the 
sales  price,  the  par  sold  and  whether  with  or  without  dividends. 
Columnar  ledgers  are  generally  used  for  this  purpose. 

Bonds  and  mortgages  as  investments  constitute  two  instru- 
ments. A  bond  is  the  instrument  which  promises  to  pay  a  certain 
sum  of  money  at  a  specified  date  at  a  certain  rate  of  interest.  The 
mortgage  is  the  instrument  which  secures  the  bond.  For  account- 
ing purposes  the  mortgage  may  be  ignored  and  the  attention 
directed  to  the  bond.  The  interest  on  this  class  of  securities 
may  be  accrued  like  that  on  any  other  bond,  and  in  closing  the 
books  cognizance  should  be  taken  of  the  amount  accrued  whether 
or  not  at  such  time  it  has  been  actually  received.  If  for  exam- 
ple, a  bond  and  mortgage  of  $10,000  bears  interest  at  the  rate  of 
5%  per  annum,  upon  closing  the  books  at  March  31st,  provided 
the  bond  has  been  held  for  the  three  months  preceding  such  date, 
the  interest  should  be  accrued  and  the  corresponding  amount  taken 
into  income.  The  entry  in  such  case  would  consist  in  charging 
accrued  interest  on  mortgage  and  crediting  interest  earned  on 
bond  and  mortgage.  The  accrued  interest  constitutes  an  asset. 
The  careful  use  of  words  in  describing  such  an  entry  is  desirable. 
By  common  consent  among  many  accountants  it  has  become  cus- 
tomary in  describing  this  asset  as  well  as  various  other  assets 
involving  accruals,  to  make  the  word  accrued  the  first  word  of 
the  title.  5or  example:  "Accrued  interest  on  bond  and  mort- 
gage," rather  than  "Interest  accrued  on  bond  and  mortgage  " 
The  former  expression  is  accepted  as  indicating  an  asset  whereas 
the  latter  is  usually  understood  to  denote  a  liability.  This  rule 
applies  as  well  to  other  forms  of  bonds,  and  the  income  from 
land  or  buildings.  Thus  in  practice  the  expressions  are  used  to 
denote  the  accrual  of  income  represented  by  assets  as  "accrued 

70 


Investments 

interest  on  securities,"  or  "accrued  rent,"  etc.  The  books  pro- 
viding for  the  record  of  the  details  in  the  case  of  bonds  and  mort- 
gages should  as  in  the  other  instances  provide  for  all  the  possi- 
bilities. There  is,  however,  in  this  case  no  question  of  par,  pre- 
mium or  discount  involved,  as  in  the  case  of  corporation  bonds 
bought  and  sold  in  the  market.  The  records  should  show  the  date 
of  the  bond,  and  date  of  maturity,  the  face  of  the  bond,  the  rate 
of  interest  and  the  dates  on  which  such  interest  is  payable.  Atten- 
tion should  in  this  case  be  given  to  any  interest  accrued  on  the 
instrument  at  time  of  acquisition  in  order  that  upon  actual  receipt 
of  the  interest  in  cash  the  proper  account  may  be  credited. 

Little  need  be  said  with  regard  to  the  detail  records  for  rent 
except  in  such  cases  as  where  tenants  are  numerous.  Instances  of 
this  kind  require  that  the  detail  records  shall  show  the  name  of 
the  tenant,  the  period  covered  by  the  lease,  the  annual  rental  and 
the  manner  in  which  it  is  payable,  whether  in  advance  or  at  the 
expiration  of  the  month. 

Two  questions  arise  frequently  concerning  the  above  men- 
tioned investments.  One  is  the  value  at  which  they  shall  be  car- 
ried in  the  balance  sheet,  and  the  second  whether  they  are  capital 
assets  or  current  assets.  In  attempting  to  answer  these  questions 
it  would  seem  that  land  and  buildings  might  be  eliminated,  for 
the  reason  that  they  could  scarcely  be  considered  as  current  assets 
under  any  circumstances  and  for  the  further  reason  that  the 
subject  has  been  discussed  rather  thoroughly  in  the  chapters 
dealing  with  land  and  buildings.  With  bonds  and  mortgages  it 
is  somewhat  different.  As  to  their  value  probably  no  one  will 
dispute  that  they  should  be  carried  at  cost.  The  fact  of  their 
being  capital  assets  is  open  to  discussion.  It  is  not  believed  that 
they  should  be  considered  current  assets,  for  the  reason  that  they 
represent  an  excess  of  capital  over  and  above  that  required  by  the 
business,  and  that  while  they  may  be  in  the  majority  of  cases 
easily  convertible  into  cash  it  is  only  in  the  event  of  some  extraor- 
dinary circumstances  or  unusual  demand  that  such  proceeding 
takes  place.  They  seem  to  be  looked  upon  more  in  the  nature  of 
fixed  capital  and  not  as  something  which  is  fluctuating  constantly 
in  conformity  with  the  volume  of  business. 

What  has  been  said  concerning  bonds  and  mortgages  in 
respect  to  their  being  current  assets  is  believed  to  be  also  true  of 
other  bonds  and  stocks.     Such  a  conclusion  eliminates  from  the 

71 


Principles  of  Accounting 

discussion  everything  then  except  as  to  the  value  at  which  they 
shall  be  carried  as  assets.  Some  organizations  adjust  them  to 
market  prices  at  closing  dates.  In  some  of  these  cases  such  a 
procedure  is  merely  a  part  of  the  policy  of  the  company,  in  other 
cases  where  the  government  exercises  supervision  and  control 
over  them,  it  is  because  of  the  requirements  of  the  government 
regulations.  To  carry  them  on  the  books  at  cost  seems  proper. 
In  showing  them  on  a  balance  sheet  it  is  desirable  to  show,  either 
as  a  footnote  or  in  parentheses  opposite  or  immediately  under  the 
caption,  the  market  value.  Where  they  are  carried  at  cost  and 
the  market  has  declined  at  closing  dates  the  effect  of  the  market 
fluctuation  is  sometimes  indicated  on  the  balance  sheet  by  a 
reserve  without  making  any  change  in  the  figures  shown  on  the 
asset  side. 

Treasury  stock  is  sottnetimes  included  under  investments. 
While  this  is  quite  proper,  precaution  should  be  taken  where  it 
is  so  included  to  make  sure  that  the  item  so  represented  is  in 
reality  treasury  stock  and  not  capital  stock  unissued.  Unfortu- 
nately the  term  treasury  stock  is  at  times  given  two  different 
meanings.  It  is  sometimes  used  to  denote  capital  stock  which  is 
unissued. 

Capital  stock  may  be  considered  as  issued  when  it  is  signed, 
sealed  and  delivered  for  value.  Until  the  last  named  of  these 
steps  has  taken  place  it  must  be  considered  as  unissued.  It  is 
hard  to  see  how  unissued  stock  can  ever  be  considered  as  an 
asset.  Up  to  the  time  of  issue  it  is  not  in  reality  capital  stock  in 
any  sense  of  the  word.  The  certificate  of  stock  is  evidence  of  the 
fact  that  capital  has  been  received  and  must  be  accounted  for  to 
the  party  from  whom  it  was  received  to  the  extent  indicated  by 
the  certificate.  The  difference  between  the  capital  received  and 
the  amount  of  capital  which  the  corporation  is  authorized  to 
secure  is  represented  by  nothing  except  figures  expressing  this 
amount.  The  words  treasury  stock  carry  with  them  a  significance 
of  value.  For  this  reason  it  appears  rather  incompatible  to  con- 
sider this  amount,  descriptive  of  nothing  but  a  measure  of  pos- 
sibilities, as  treasury  stock. 

If  the  evidence  of  receipt  of  capital,  namely  a  certificate  of 
stock  has  once  been  issued  for  money  or  property,  then  something 
of  value  attaches  to  it  and  it  becomes  representative  of  an  asset 
Stock  issued  in  this  manner  and  subsequently  acquired  has  a 

72 


Investments 

value,  instead  of  being  a  worthless  piece  of  paper,  it  represents 
something  for  which  value  has  been  received.  Upon  having  been 
acquired  subsequent  to  its  original  issue  for  value,  it  may  be 
properly  considered  as  treasury  stock.  To  acquire  it  presumably 
means  that  the  accountability  for  capital  for  which  it  was  orig- 
inally issued  has  been  reduced.  Why  not  then  ask  the  question, 
"Why  is  it  carried  in  the  treasury?"  "Why  not  cancel  the  ac- 
countability represented  on  the  books  by  the  capital  stock  out- 
standing accounts  ?"  The  answer  to  these  questions  is  that  there 
is  a  possibility  that  it  may  again  be  issued  or  in  reality  sold,  and 
it  seems  useless  to  go  to  the  trouble  of  cancelling  the  outstanding 
accountability  and  subsequently  restoring  it  in  accordance  with 
the  fluctuations  of  treasury  stock.  Then  there  is  the  added  reason 
that  the  original  issue  of  capital  stock  cannot  be  disposed  of  at 
less  than  par  without  a  corresponding  liability  for  the  difference 
between  what  it  was  issued  for  and  par  attaching  to  it.  Treasury 
stock  is  presumed  to  have  been  issued  once  for  its  par  value  and 
therefore  may  subsequently  be  sold  at  any  price  or  given  away  if 
desired.  Attention  is  again  called  to  the  fact  that  if  treasury 
stock  is  shown  on  the  books  or  balance  sheet  as  an  investment  or 
in  fact  in  any  other  group  of  assets,  the  above  mentioned  distinc- 
tions must  be  observed. 

REFERENCES  FOR  COLLATERAL  READING: 

Accounting  Practice  and  Procedure,  Dickinson,  pages  38, 
82-87,  116-118. 

Modern  Accounting,  Hatfield,  pages  90-97. 

Accountancy  of  Investment,  Sprague  and  Perrine. 

Auditing  Theory  and  Practice,  Montgomery,  pages  113,  362- 
365. 


73 


CHAPTER  XII 

WORKING  AND  TRADING  ASSETS 

This  group  comprises  materials  and  supplies,  goods  in  process, 
finished  goods,  finished  parts  purchased  to  complete  manufactured 
goods,  packing  material,  coal,  oil  and  waste,  stationery,  adver- 
tising matter,  postage  and  any  inventories  similar  in  their  nature 
to  the  foregoing.  They  are  physical  assets  which  are  consumed 
either  in  the  manufacture  of  the  goods  or  the  conduct  of  the 
business.  They  are  called  working  and  trading  assets  because 
they  are  the  assets  which  the  organization  is  working  into  goods 
for  sale  or  into  expenses  attending  such  operation  or  because  they 
are  assets  which  are  on  hand  for  sale  or  trading  purposes. 

The  accounts  for  items  in  this  group  are  used  in  practice  in 
three  distinct  ways.  The  first  is  to  combine  the  old  inventory 
and  the  purchases  in  one  account  and  determine  the  consump- 
tion by  the  inventory  method  of  crediting  the  new  inventory  and 
closing  out  the  balance  to  a  consumption  account.  The  second  is 
to  combine  the  old  inventory  and  the  purchases  in  one  account 
and  determine  the  consumption  by  the  direct  method,  so  that 
crediting  the  amount  consumed  to  the  asset  account  will  show  the 
inventory.  The  third  way  is  to  run  separate  accounts  for  inven- 
tories and  purchases.  The  inventory  is  entered  in  the  asset  ac- 
count both  at  the  beginning  and  at  the  end  of  the  period  and  the 
difference  only,  whether  it  be  debit  or  credit  carried  to  the  con- 
sumption account.  The  consumption  account  as  used  herein  is 
used  in  a  broad  sense.  The  term  is  intended  to  mean  any  nom- 
inal account  into  which  working  or  trading  assets  may  be  closed. 
It  would  embrace  manufacturing  cost,  cost  of  goods  sold  and 
expense  accounts  such  as  stationery  and  printing  expense,  postage 
expense,  etc. 

In  the  illustrations  of  the  varieties  of  practice  which  follow 
let  these  facts  with  regard  to  materials  and  supplies  remain  con- 
stant: inventory  December  31,  1910,  $20,000;  purchases,  $15,000; 
inventory  December  31,  1911,  $28,000;  consumption,  $7,000. 

In  the  first  case,  the  account  becomes  a  mixed  one.  It  par- 
takes of  the  nature  of  both  a  real  and  a  nominal  account.  At 
the  beginning  it  is  a  real  account.    During  the  period  it  is  a  mixed 

74 


Working  and  Trading  Assets 

account.  In  construction  it  is  precisely  like  the  old-fashioned 
merchandise  account.  In  operation  it  is  also  identical.  It  is 
opened  on  the  debit  side  with  the  inventory  at  the  beginning  of 
the  period.  It  is  charged  with  the  purchases.  It  is  credited  with 
the  inventory  at  the  end  of  the  period.  It  is  closed  by  the  balance 
in  the  account  which  is  carried  to  the  consumption  or  manufactur- 
ing account.  Thus,  if  to  the  inventory  at  the  beginning  of  the 
period  of  $20,000  we  add  the  purchases  of  $15,000  there  is 
$35,000  to  be  accounted  for.  If  at  the  end  of  the  period  $28,000 
remains  on  hand,  $7,000  must  have  been  consumed  or  have  dis- 
appeared. It  will  be  seen  that  the  amount  of  material  has  been 
determined  by  the  inventory  method.  The  accounts  would  appear 
as  follows : 

Materials  and  Supplies 


Inventory,  beginning .   $ 2 o, 000 
Purchases 15,000 


$35>ooo 


Inventory,  end $28,000 

Consumption 7,000 


$3S.ooo 


Inventory,  new $28,000 

Consumption  Account 

Materials  and  supplies    $7,000 

In  the  second  case,  the  account  can  scarcely  be  called  a  mixed 
one.  It  might  appear  without  thought  to  partake  of  the  nature 
of  both  a  real  and  a  nominal  account.  It  does  not,  however,  since 
the  consumption  is  determined  by  the  direct  method.  When  the 
account  is  used  in  this  way  the  materials  and  supplies  are  usually 
issued  on  requisition.  The  requisition  when  honored  and  priced 
becomes  the  basis  of  a  charge  to  the  consumption  account  and  a 
corresponding  credit  to  materials  and  supplies  account.  It  is  true 
of  course  that  for  convenience  the  requisition  will  be  summarized 
and  the  aggregate  amount  credited  to  the  materials  and  supplies 
account  only  at  the  end  of  the  month,  or  end  of  the  accounting 
period.  Theoretically,  however,  the  materials  and  supplies  ac- 
count is  reduced  every  time  a  requisition  is  filled. 

In  many  instances  the  consumption  is  determined  by  keeping 

75 


Principles  of  Accounting 

a  running  stock  account  with  each  class  of  material  or  stock.  The 
determining  of  consumption  does  not  necessarily  depend  upon 
the  use  of  requisitions.  The  stock  account  may  be  kept  in  a  book, 
either  bound,  or  composed  of  loose  leaves,  or  upon  cards.  For 
convenience  cards  are  sometimes  located  adjacent  to  the  stock 
itself.  The  location  of  the  record  has  little  bearing  upon  the 
method  so  long  as  there  is  an  account  for  each  class  of  stock. 
Given  such  accounts,  they  are  debited  with  the  opening  inventory. 
They  are  subsequently  charged  with  any  receipts,  whether  by  pur- 
chase or  otherwise.  They  are  credited  with  all  issues  at  the  time 
the  issues  are  made.  The  balance  in  the  account  should  show  the 
stock  on  hand. 

In  connection  with  stock  records,  the  question  frequently 
arises,  "what  shall  be  done  when  the  balance  in  the  stock  accounts 
does  not  agree  with  the  physical  inventory?"  The  disposition  of 
such  discrepancies  must  necessarily  depend  upon  the  cause.  There 
are  various  things  which  cause  the  difference  which  may  arise. 
One  is  failure  to  enter  all  receipts  on  the  debit  side  of  the  ac- 
count. Another  is  an  error  in  footing  the  debit  side.  Still  another 
may  be  failure  to  record  an  issue  on  the  credit  side.  It  is  also 
possible  that  the  actual  stock  issued  did  not  agree  with  the  record 
which  was  made  of  the  issue  or  that  the  credit  side  of  the  account 
has  been  incorrectly  footed.  An  attempt  should  first  be  made  to 
correct  any  of  the  above  mentioned  causes  of  the  discrepancy. 
If  such  measures  prove  ineffectual  the  account  should  be  adjusted 
to  agree  with  the  physical  inventory. 

The  question  which  now  presents  itself  is  "which  complimen- 
tary account  shall  be  affected  by  the  difference  ?"  If  the  physical 
inventory  is  greater  than  the  book  inventory  the  stock  account 
must  be  charged.  Which  account  is  to  be  credited,  consumption 
or  profit  and  loss?  If  the  physical  inventory  is  less  than  the 
book  inventory  the  stock  account  must  be  credited.  Which 
account  is  to  be  charged,  consumption  or  profit  and  loss  ?  If  the 
consumption  account  is  charged  or  credited  the  cost  of  the  goods 
manufactured  or  sold  will  be  affected  accordingly.  Supposing, 
for  example,  that  profit  and  loss  has  been  charged  for  a  shortage 
which  although  not  clearly  shown  by  the  accounts  was  actually 
consumed  in  the  manufacture  of  goods.  The  cost  of  manufacture 
will  be  incorrect  to  the  extent  of  the  shortage  thus  charged.  On 
the  other  hand  suppose  that  the  difference  was  due  to  theft  and 

76 


Working  and  Trading  Assets 

instead  of  being  charged  to  profit  and  loss  the  amount  was 
charged  to  consumption  or  cost  of  manufacture.  Again  the  con- 
sumption account  would  be  incorrect  to  the  extent  of  the  shortage. 
To  frame  a  hard  and  fast  rule  in  this  case  is  a  difficult  one.  The 
best  apparently  that  can  be  done  is  to  say  that  the  consumption 
account  should  be  adjusted  in  accordance  with  any  necessary 
adjustments  to  the  stock  account,  except  where  it  is  known  defin- 
itely that  the  consumption  account  has  not  been  affected,  when  the 
adjustment  should  be  carried  to  profit  and  loss. 

The  general  ledger  account,  controlling  any  subsidiary  records 
of  stock,  would,  where  the  direct  method  of  ascertaining  the 
consumption  is  in  force,  appear  as  follows : 

Materials  and  Supplies 


Inventory,  beginning .   $20,000 
Pvurchases 15,000 


$35,000 


Consumption $7,000 

Inventory,  end 28,000 


$35,000 


Inventory,  new $28,000 

Consumption  Account 


Materials  and  Supplies  $7,000 

The  third  method  of  arriving  at  the  consumption  it  will  be 
remembered  contemplated  both  an  inventory  account  and  a  pur- 
chase account.  The  inventory  account  would  show  the  inventory 
at  the  beginning  on  the  debit  side  with  the  inventory  at  the  end 
on  the  credit  side.  At  the  time  of  placing  the  inventory  at  the 
end  on  the  credit  side  it  would  be  carried  down  on  the  debit  side 
to  constitute  the  opening  inventory  for  the  next  period.  The 
balance  in  the  inventory  account  would  be  carried  to  the  purchase 
account.  The  effect  of  this  procedure  would  be  to  increase  or 
decrease  the  purchases  for  the  period,  depending  upon  whether 
the  inventory  at  the  end  were  larger  or  smaller  than  at  the  begin- 
ning. The  purchase  account  thus  adjusted  would  be  closed  out 
to  the  manufacturing  cost  account  or  to  the  account  for  cost  of 
goods  sold.  Using  again  the  same  figures  as  heretofore  the  ac- 
counts would  appear  as  follows: 

77 


Principles  of  Accounting 
Inventory  Account 


Inventory,  beginning  $20,000 
Balance  to  purchases .       8, 000 

$28,000 


Inventory,  end $28,000 


$28,000 


Purchase  Account 


Purchases $15,000 


$15,000 


Increase  in  inventory .     $8,000 
Consvimption 7,000 

$15,000 


Consumption  Account 


Materials  and  Supplies  $7,000 

The  latter  method  just  described  is  illustrated  in  the  state- 
ment of  income  and  profit  and  loss  wherein,  the  section  dealing 
with  cost  of  goods  sold,  shows  first  the  purchases  and  second  the 
application  of  the  inventory.  This  form  of  presentation  is  fre- 
quently difficult  for  the  student  to  understand  because  of  the 
terms  used.  Unless  they  be  analyzed  as  to  their  meaning  they 
strike  one  off-hand  as  being  somewhat  contradictory.  The  con- 
fusion seems  to  arise  when  the  expressions  add  decrease  of  in- 
ventory and  deduct  increase  of  inventory  are  used.  This  point 
might  be  cleared  up  if  one  would  stop  to  reason  as  follows :  The 
cost  of  the  materials  and  supplies  consumed  for  the  period  is 
$7,000.  This  is  represented  by  purchases  amounting  to  $15,000, 
and  an  increase  in  inventory  of  $8,000,  which  is  deducted  from 
the  purchases  of  $15,000.  Why  do  we  deduct  the  increase  in 
inventory?  Because  of  the  fact  that  there  has  been  consumed 
not  the  amount  purchased,  $15,000,  but  $15,000  less  the  $8,000, 
which  remains  unconsumed  and  appears  in  the  inventory  at  the 
end  of  the  period,  $28,000.  Conversely  the  same  thing  would 
be  true.  If  the  purchases  for  the  period  were  the  same  $15,000, 
the  inventory  at  the  beginning  being  $28,000,  and  the  inventory 
at  the  end  $20,000,  then  the  cost  of  the  materials  and  supplies 

78 


Working  and  Trading  Assets 

consumed  during  the  period  would  be  $23,000,  represented  by 
purchases  of  $15,000  plus  a  decrease  in  the  inventory  of  $8,000. 
This  may  be  reasoned  out  by  following  the  facts  which  show  that 
while  $15,000  worth  of  materials  were  purchased  during  the 
period,  $8,000  worth  more  have  been  used  and  have  been  deducted 
from  the  inventory  at  the  beginning  of  $28,000,  making  the 
inventory  at  the  end  $20,000.  . 

It  is  to  be  noted  that  applying  the  difference  in  inventory 
method  to  the  materials  and  supplies,  goods  in  process,  finished 
parts  to  complete  goods  in  process  and  finished  goods,  taking 
into  consideration  any  purchases,  will  give  the  cost  of  the  goods 
sold  during  the  period.  To  illustrate  this  let  the  following  series 
of  transactions  be  followed:  Inventories  at  the  beginning;  ma- 
terials and  supplies,  $10,000;  goods  in  process,  $40,000;  finished 
parts,  $8,000;  finished  goods,  $75,000;  purchases  of  materials  and 
supplies,  $20,000.  Inventories  at  the  end;  materials  and  sup- 
plies, $5,000;  goods  in  process,  $12,000;  finished  parts,  $2,000; 
finished  goods,  $34,000.  The  account  with  the  materials  and 
supplies  inventory  would  show  an  opening  balance  of  $10,000, 
a  closing  balance  of  $5,000,  with  $5,000  carried  to  the  materials 
and  supplies  purchase  account.  This  latter  account,  amounting 
now  to  $25,000,  would  be  closed  out  to  the  goods  in  process 
account.  The  goods  in  process  account,  opening  with  a  balance 
of  $40,000,  would  show  a  debit  of  $25,000  for  materials  and 
supplies,  a  debit  of  $6,000  coming  from  the  account  for  finished 
parts  or  total  debits  amounting  to  $71,000.  The  credits  in  the 
goods  in  process  account  would  comprise  $12,000,  the  closing 
inventory  and  $59,000  transferred  to  the  finished  goods  account. 
The  finished  goods  account  would  show  an  opening  balance  of 
$75,000,  a  debit  of  $59,000,  credits  of  $34,000,  covering  the  new 
inventory,  and  $100,000,  which  would  be  transferred  to  the 
account  for  cost  of  goods  sold.  If  instead  of  tracing  the  transac- 
tions through  the  above  named  steps  in  the  respective  account 
the  differences  in  inventories  were  to  be  carried  direct  to  the  cost 
of  goods  sold  account,  it  would  show  various  debits  comprising 
difiFerence  in  inventory  of  materials  and  supplies  of  $5,000,  pur- 
chases $20,000,  difference  in  inventory  goods  in  process  $28,000, 
difference  in  inventory  of  finished  parts  $6,000,  difference  in 
inventory  of  finished  goods  $41,000,  or  a  total  of  $100,000. 

Of  the  miscellaneous  items  found  in  this  group  of  assets,  such 

79 


Principles  of  Accounting 

as  stationery  and  printing,  postage,  etc.,  comparatively  little  need 
be  said  apparently.  In  some  concerns  stock  accounts  are  kept 
with  those  items  and  the  amount  chargeable  to  operations  deter- 
mined by  requisitions  issued.  In  other  cases  the  amount  charge- 
able to  operations  is  determined  by  taking  an  inventory,  placing 
upon  it  a  value  and  charging  off  the  difference  in  the  account  to 
operations.  The  materials  and  supplies,  goods  in  process,  etc., 
are  of  course  closely  related  to  cost  accounting.  These  accounts 
serve  as  controlling  accounts  for  the  cost  department,  and  where 
such  department  exists  are  usually  supported  by  subsidiary  rec- 
ords showing  the  details. 

Possibly  the  most  interesting  phase  of  the  discussion  in  con- 
nection with  the  inventory  is  the  values  at  which  items  like  mate- 
rials and  supplies,  goods  in  process,  and  finished  goods  shall  be 
carried.  Some  proprietors  insist  that  they  shall  be  carried  at 
market  prices.  Some  text-books  advocate  carrying  them  at  cost 
except  where  the  cost  is  lower  than  the  market  price,  when  they 
should  be  carried  at  the  market  price.  It  would  seem  that  in 
order  to  be  consistent  one  basis  should  be  the  rule  in  all  cases. 
There  is  decided  objection  to  carrying  them  at  market  prices  or 
sale  prices,  when  same  is  higher  than  cost,  because  of  the  fact  that 
such  procedure  anticipates  profits.  Materials  and  supplies  if  car- 
ried at  market  prices  may  show  either  a  profit  or  a  loss  when  the 
cost  of  the  materials  and  supplies  is  compared  with  the  market 
price.  What  seems  to  be  a  fact  is  that  materials  and  supplies  on 
hand  will  be  used  in  the  product  and  not  sold  as  materials  and 
supplies  if  the  market  is  above  cost,  or  withheld  from  use  and  new 
supplies  purchased  if  the  market  is  below  cost.  It  would  appear 
to  be  a  pretty  good  rule  with  regard  to  materials  and  supplies  to 
carry  them-  in  the  inventory  at  cost.  Their  value  if  the  market 
is  lower  than  cost  may  be  shown  on  the  balance  sheet  by  opposing 
against  the  cost  a  reserve  for  decline  in  market  values.  Such 
procedure  accomplishes  two  things.  If  the  concern  is  ultracon- 
servative  and  wishes  to  be  exact,  the  true  market  value  of  the 
inventory  is  thus  stated  in  the  balance  sheet,  and  at  the  same  time 
the  account  for  materials  and  supplies  maintains  its  true  relation 
to  the  details  of  which  it  is  composed  and  continues  to  be  a  con- 
trolling account  in  the  strict  sense  of  the  word.  There  is  no 
objection  and  in  fact  it  is  considered  more  nearly  correct  to  include 

80 


Wo f  king  and  Trading  Assets 

in  the  pricing  of  inventory  of  materials  and  supplies  the  inward 
freight,  cartage,  etc.,  applicable  to  the  goods  remaining  on  hand. 

With  goods  in  process  the  question  of  valuation  becomes 
somewhat  more  complex.  Such  goods  will  include  in  addition  to 
the  materials  and  supplies  the  labor  and  certain  portions  of  the 
manufacturing  overhead.  The  question  presenting  itself  in  this 
connection  is  whether  or  not  such  goods  shall  be  carried  at  prime 
cost,  which  includes  merely  materials  and  supplies  and  direct 
labor,  or  whether  they  shall  be  carried  at  manufacturing  cost, 
which  includes  in  addition  to  prime  cost  the  manufacturing  over- 
head. The  latter  basis  is  undoubtedly  the  more  equitable,  but  if 
desired  or  indicated  by  ultraconservatism  the  overhead  may  be 
offset  by  a  reserve  which  will  have  the  effect  in  the  balance  sheet 
of  carrying  the  goods  at  their  prime  cost. 

Finished  goods  involve  in  their  cost  an  item  of  general  over- 
head which  is  comprised  of  the  selling,  administrative  and  other 
expenses.  If  it  is  equitable  to  carry  goods  in  process  of  manu- 
facture at  manufacturing  cost,  then  it  would  seem  equitable  also 
to  carry  the  finished  goods  at  selling  cost.  The  objection  to  this 
lies  in  the  fact  that  in  so  doing  a  portion  of  the  general  overhead 
expense  is  capitalized  and  such  procedure  is  questionable.  The- 
oretically it  is  correct  to  carry  finished  goods  at  selling  cost. 
Practically  it  is  objected  to  because  of  the  fact  that  it  shows  as 
an  asset  a  proportion  of  expense  applicable  to  the  unsold  product. 
It  is  hard  to  say  why  a  distinction  should  be  made  between  de- 
ferring charges  to  operations  for  such  items  as  insurance  for  the 
unexpired  proportion  thereof,  whereas  the  expenses  of  a  given 
period  are  all  charged  up  against  the  product  sold  during  that 
period,  when  a  portion  of  such  expenses  must  in  the  nature  of 
things  apply  to  product  completed  in  one  period  and  sold  in 
subsequent  period,  which  period  will  benefit  in  the  matter  of 
profit  proportionately.  It  is  probably  true  that  in  the  case  of  a 
business  in  which  the  manufacture  and  sale  of  the  product  is  uni- 
form that  it  will  not  make  great  difference.  Most  authorities 
advocate  carrying  finished  goods  at  manufacturing  cost,  but  when 
it  is  desirable  to  maintain  control  over  underlying  records  by 
carrying  them  at  selling  cost,  both  results  may  be  accomplished 
by  setting  up  a  reserve  on  the  balance  sheet  for  the  proportion 
of  general  overhead  expense  which  the  selling  costs  contain. 


8i 


CHAPTER  XIII 

CURRENT  ASSETS 

Current  assets  will  be  remembered  as  those  assets  which  are 
immediately  available  or  which  will  become  available  shortly  for 
the  purpose  of  meeting  current  liabilities.  Chief  among  them, 
of  course,  is  cash,  either  in  hand,  on  deposit,  or  in  the  form  of 
working  funds.  Some  of  the  others  are  accounts  receivable  and 
notes  receivable.  The  group  also  includes  accruals  of  earnings  of 
every  description,  such  as  accrued  interest  on  bonds,  dividends 
receivable  on  stocks,  accrued  interest  on  notes  and  accounts 
receivable,  etc.  Separate  accounts  for  each  of  these  items  will 
usually  appear  in  the  general  ledger,  although  cash  in  hand  and 
on  deposits  is  frequently  consolidated  in  the  balance  sheet. 

Cash  in  hand  is  sometimes  known  as  petty  cash.  Working 
funds  are  sometimes  known  as  petty  cash.  There  should  never 
be  any  .question  as  to  whether  or  not  an  account  for  cash  should 
appear  in  the  ledger.  It  is  to  be  presumed  that  a  general  ledger 
which  has  been  posted  up  will  permit  of  a  trial  balance  being  taken 
from  it.  This  would  not  be  possible  if  the  ledger  did  not  include 
a  cash  account  and  such  exclusion  would  constitute  a  violation  of 
the  principles  upon  which  a  general  ledger  is  run. 

It  is  difficult  to  describe  any  fixed  rule  for  the  handling  of 
cash  and  cash  accounts.  In  some  cases  there  will  be  but  one 
account  for  cash  in  the  general  ledger.  Under  such  circum- 
stances all  receipts  and  disbursements  are  put  through  one  cash 
book  and  if  there  be  petty  cash  accounts  or  other  cash  funds, 
books  for  such  classes  of  items  will  be  made  subsidiary  to  the 
general  cash  book.  This  method  of  handling  the  cash  is  some- 
what complicated.  The  debit  side  will  show  receipts  of  every 
description,  whether  deposited  in  the  bank  or  not.  The  credit  side 
will  show  disbursements  of  every  kind,  whether  by  check  or  in 
actual  cash.  The  balance  of  the  cash  account  in  the  general  ledger 
will  require  for  proof  the  adding  together  of  the  cash  in  bank 
and  the  cash  in  hand. 

The  scheme  of  classifying  the  cash  and  maintaining  in  the 
general  ledger  separate  accounts  for  each  kind  or  class  is  largely 
used.     Where  there  is  cash  in  bank,  petty  cash  and  working 

82 


Current  Assets 

funds,  there  should  be  separate  accounts  in  the  general  ledger 
for  cash  in  bank,  petty  cash  and  working  funds.  It  is  highly 
important  that  all  cash  receipts  of  whatever  nature  should  be 
deposited  in  the  bank.  If  such  method  be  followed  the  general 
cash  book  will  show  only  receipts  on  the  one  side  and  disburse- 
ments by  check  on  the  other  side.  The  balance  in  the  cash  book 
will  agree  with  the  balance  shown  in  the  ledger  and  may  be  easily 
reconciled  to  the  balance  reported  by  the  bank.  For  miscella- 
neous disbursements  and  the  establishment  of  working  funds 
checks  should  be  drawn  and  the  amounts  involved  charged  to  the 
respective  accounts,  namely  petty  cash  and  working  funds.  A 
separate  cash  book  will  be  kept  for  petty  cash  which  will  show  on 
the  debit  side  only  receipts  from  general  cash  or  cash  in  bank 
and  on  the  credit  side  actual  cash  disbursements.  The  balance  in 
the  petty  cash  book  at  the  end  of  the  month  will  agree  with  the 
account  for  petty  cash  in  the  general  ledger  after  the  posting  has 
been  made.  Such  a  segregation  makes  it  possible  to  control  the 
petty  cash  and  in  reality  it  partakes  of  the  nature  of  a  working 
fund  except  that  the  amounts  transferred  from  the  general  cash 
may  vary  from  month  to  month. 

A  working  fund  or  an  imprest  cash  fund  is  a  definite  sum, 
adequate  to  meet  the  demand  for  disbursements  which  the  volume 
of  transactions  during  a  definite  period  necessitates,  and  which 
will  at  all  times  if  properly  conducted  show  either  actual  cash,  or 
cash  and  paid  vouchers,  agreeing  in  total  with  the  amount  set 
aside.  Such  provisions  are  frequently  made  for  general  cashiers, 
department  cashiers,  traveling  salesmen,  or  other  employees  en- 
gaged in  traveling,  and  branch  office  managers  or  cashiers.  For 
example,  suppose  that  the  expenses  of  the  Chicago  office  of  a  New 
York  concern  amounted  approximately  to  $1,200  a  month.  In 
order  that  the  manager  of  the  Chicago  office  might  at  all  times 
have  ample  funds  on  hand  out  of  which  to  meet  current  expenses, 
it  is  probable  that  not  less  than  $1,500  would  be  forwarded  to 
him  by  check.  This  would  constitute  his  working  fund.  The 
amount  would  be  charged  on  the  general  ledger  at  New  York  to 
a  Chicago  fund  account.  The  cashier  of  the  Chicago  office 
would  from  time  to  time,  as  he  made  disbursements,  replace  the 
cash  with  vouchers.  At  all  times  if  his  accounts  were  correct  he 
should  have  $1,500,  either  in  cash  or  represented  by  vouchers. 
At  the  end  of  the  month  when  he  made  up  his  cash  report  he 

83 


principles  of  Accounting 

would  classify  the  expenses  in  accordance  with  instructions  and 
forward  it  to  the  New  York  office.  There  would  of  course  be 
an  interval  of  a  few  days  during  which  time  he  would  have  noth- 
ing to  show  for  his  disbursements  except  a  copy  of  the  report. 
He  would,  however,  in  effect  have  an  account  receivable  from 
the  New  York  office  for  the  exact  amount  of  vouchers  which 
he  had  transmitted.  Upon  receipt  of  the  report  at  the  New  York 
office  it  might  be  journalized,  put  through  a  distribution  book  or 
put  through  the  voucher  register.  Regardless  of  how  it  was 
handled  the  expenses  would  be  charged  to  the  appropriate  account 
and  the  amount  of  the  disbursements  credited  to  the  Chicago 
fund  account.  A  check  would  subsequently  be  issued  for  the 
amount  of  the  disbursements  to  the  Chicago  office,  thereby  re- 
storing the  fund  to  $i,5cx>. 

The  question  sometimes  arises  as  to  whether  the  credits  to 
the  working  fund  account  for  disbursements  and  subsequent 
charges  to  the  account  in  precisely  similar  amounts  for  reimburse- 
ments should  be  shown  in  the  ledger  account  for  working  funds. 
It  seems  that  this  should  be  done  if  for  no  other  than  historical 
purposes.  It  is  true  of  course  that  the  account  will  show  the 
amount  of  the  fund  as  an  opening  item,  with  offsetting  debits  and 
credits  each  month,  resulting  in  a  balance  representing  the  amount 
of  the  fund.  This  may  appear  to  be  of  no  value  but  it  would 
seem  to  have  the  effect  of  showing  that  disbursements  had  been 
reported  from  time  to  time  and  checks  for  reimbursement  had 
been  issued.  Working  funds  will  usually  be  carried  in  the  balance 
sheet  as  current  assets. 

Accounts  receivable  as  a  balance  sheet  caption  may  represent 
merely  accounts  with  regular  customers  or  it  may  comprise  ac- 
counts receivable  of  every  description.  The  accounts  with  cus- 
tomers will  usually  be  represented  by  a  controlling  account  sup- 
ported by  underlying  ledgers,  whereas  occasion  may  require  that 
separate  general  ledger  accounts  be  opened  with  parties  other 
than  customers,  who  are  indebted  to  the  concern.  The  books  for 
customer  accounts  vary  in  form  and  arrangement.  The  accounts 
are  sometimes  separated  into  several  volumes  for  the  purpose  of 
facilitating  the  bookkeeping  work,  controlling  individually  the 
work  of  various  bookkeepers,  controlling  certain  classes  of  busi- 
ness, or  certain  territories. 

For  balance  sheet  purposes  accounts  are  frequently  classijfied 

84 


Current  Assets 

as  good,  doubtful  and  bad,  and  reserves  are  introduced  to  provide 
for  the  bad  and  doubtful  ones.  It  is  a  matter  of  question  as  to 
how  long  an  account  should  be  carried  before  being  considered 
bad.  It  is  questionable  further  as  to  whether  an  account  which 
is  considered  bad  shall  actually  be  charged  off  against  the  reserve 
until  it  is  proven  absolutely  that  the  amount  will  not  be  collected. 
A  good  account  may  become  tainted  and  doubtful.  It  may  subse- 
quently be  declared  bad  and  impossible  of  collection.  Such  a 
decision,  however,  is  merely  as  a  rule  an  opinion.  Accounts 
which  are  undisputably  bad  may  eventually  produce  something. 
A  man  who  will  not  pay  may  be  sued,  a  judgment  secured  and 
the  amount  collected,  if  he  has  anything.  Sometimes  a  man  would 
like  to  pay  and  cannot.  Bankruptcy  follows  and  the  creditors 
receive  a  pro  rata  share  of  their  claims  in  liquidation.  In  the 
writer's  opinion  an  account  should  not  be  written  off  against  a 
reserve  until  such  time  as  a  judgment  has  been  returned  unsatis- 
fied or  if  the  account  is  involved  in  bankruptcy  where  the  final 
liquidation  dividend  has  been  received.  Writing  off  accounts 
promiscuously  frequently  leads  to  trouble,  for  the  reason  that 
accounts  written  off  may  subsequently  be  collected  and  upon 
receipt  of  the  money,  if  no  record  of  the  account  has  been  kept, 
it  may  be  appropriated  by  dishonest  employees.  If  bad  accounts 
are  carried  on  the  books  and  adequate  provision  is  made  in  the 
reserve,  it  would  seem  to  have  the  desired  effect  in  so  far  as 
valuation  is  concerned  and  still  preclude  any  possibility  of  writing 
off  an  account  and  having  it  subsequently  collected  without  a 
record  of  the  collection  being  made. 

To  pacify  ledger  clerks,  or  bookkeepers  on  underlying  ledgers, 
accounts  which  are  considered  bad  are  sometimes  transferred  to 
a  suspense  ledger.  This  procedure  has  the  effect  of  relieving  the 
bookkeeper  from  including  such  accounts  in  his  trial  balance 
month  after  month  and  still  makes  it  possible  to  preserve  the 
record  of  the  accounts  until  they  are  lost  beyond  question.  Many 
concerns  provide  against  losses  on  bad  accounts  by  carrying  credit 
indemnity  or  credit  insurance,  in  which  case  a  premium  is  paid 
the  same  as  in  the  case  of  fire,  life  or  other  insurance. 

As  an  asset  a  note  is  apt  to  be  looked  upon  as  better  than  an 
account.  This  opinion  is  questionable  since  neither  is  preferred 
over  the  other  in  bankruptcy  proceedings  or  in  liquidation.  The 
main  legal  difference  between  a  note  and  an  account  is  that  the 

85 


Principles  of  Accounting 

former  in  effect  confesses  judgment  as  to  the  amount  and  requires 
no  further  proof  in  this  respect,  whereas  in  bringing  action  to 
collect  on  an  account  all  the  items  making  up  the  account  must 
be  proven.  Care  should  be  taken  to  distinguish  notes  from  bills. 
This  distinction  is  made  very  clear  in  the  New  York  negotiable 
instruments  law  which  requires  that  the  word  note  shall  only  be 
used  for  the  purpose  of  describing  a  promissory  note,  whereas 
the  word  bill  shall  be  understood  to  mean  a  bill  of  exchange,  either 
foreign  or  domestic.  A  bill  of  exchange  is  a  draft  which  in  reality 
partakes  somewhat  of  the  nature  of  a  check.  It  is  a  request  ad- 
dressed to  party  number  one  by  party  number  two  to  pay  a  certain 
amount  of  money  to  party  number  three.  If  accepted  by  party 
number  two  it  becomes  in  effect  a  note,  except  for  the  fact  that 
it  does  not  usually  bear  interest. 

Notes  may  be  interest  bearing  or  non-interest  bearing.  In 
some  cases  the  note  will,  for  example,  call  for  the  payment  of 
$i,ooo  on  a  certain  date  with  interest  at  6%.  In  other  instances 
where  it  is  the  intention  to  pay  interest  on  $i,ooo,  instead  of  such 
sum  being  specified  in  the  body  of  the  note,  it  might  call,  for 
example,  for  the  payment  of  $1,023.59  at  a  given  date.  It  is  im- 
portant that  notes  should  be  scrutinized  carefully  in  this  respect 
on  account  of  the  effect  which  one  or  the  other  of  these  conditions 
may  have  upon  the  treatment  of  interest.  If  the  balance  in  the 
account  of  a  given  customer  is  $1,000,  and  the  customer  remits  in 
settlement  of  the  account  a  note  for  $1,000  bearing  interest  at  6%, 
upon  receipt  of  the  note  one  entry  only  is  necessary;  a  credit  to 
accounts  receivable  and  a  charge  to  notes  receivable.  If,  however, 
the  end  of  the  accounting  period  falls  within  the  period  covered 
by  the  time  stated  in  the  note,  then  in  closing  the  books,  cognizance 
must  be  taken  of  the  interest  on  such  note  which  has  run  from 
the  date  of  the  note  to  the  end  of  the  accounting  period.  The 
entry  covering  this  accrual  would  consist  in  charging  interest  on 
notes  receivable  and  crediting  interest  earned  on  notes  receivable. 
When  subsequently  the  note  is  paid  with  interest  a  somewhat 
more  involved  entry  becomes  necessary.  The  amount  of  cash 
received  covers  not  only  the  face  of  the  note,  but  the  interest 
thereon.  The  amount  involved  will  presumably  be  greater  than 
the  face  of  the  note  and  accrued  interest  which  was  set  up  at 
the  previous  closing  date.  Therefore  the  payment  in  reality  in- 
cludes three  things,  namely,  the  face  of  the  note  which  appeared 

86 


Current  Assets 

among  the  notes  receivable,  the  amount  of  the  accrued  interest 
which  was  contained  in  the  corresponding  account,  and  an  amount 
of  interest  which  has  as  yet  received  no  treatment  so  far  as  the 
books  are  concerned.  Thus  to  cover  such  a  transaction  when 
cash  is  charged,  the  three  accounts  to  be  credited  are  notes  re- 
ceivable, accrued  interest  on  notes  receivable,  and  interest  earned 
on  notes  receivable. 

Where  the  face  of  the  note  includes  the  interest,  the  interest 
must  be  credited  upon  receipt  of  the  note  to  the  interest  earned 
account  rather  than  to  the  customer.  In  such  an  event  care  must 
be  taken  upon  closing  the  books  to  see  that  the  unearned  propor- 
tion of  such  interest  received  in  advance  is  properly  set  up.  If 
a  note  for  $1,030,  dated  June  ist  and  payable  six  months  later 
appeared  upon  the  books,  at  closing  time  provision  should  be 
made  for  the  unearned  proportion  by  deferring  it  to  a  subsequent 
period.  When  the  note  for  $1,030  was  received,  presumably 
notes  receivable  were  charged  with  $1,030,  while  the  customer 
was  credited  with  $1,000,  and  interest  earned  with  $30.00.  Upon 
closing  the  books  on  June  30th,  5/6  of  the  interest  appears  to 
have  been  unearned  and  the  proper  entry  charging  interest  earned 
on  notes  receivable  and  crediting  interest  unearned  on  notes 
receivable  would  be  in  order. 

The  notes  receivable  are  usually  represented  by  a  controlling 
account  in  the  general  ledger  in  which  at  times  the  accrued  inter- 
est is  included.  It  is  thought  to  be  better  accounting,  however,  to 
use  a  separate  account  for  such  items  so  that  as  far  as  possible 
the  notes  receivable  account  will  show  nothing  but  the  face  of  the 
note.  Various  forms  of  subsidiary  records  are  in  use  for  the 
purpose  of  carrying  notes  receivable,  but  whatever  the  form  it  is 
essential  that  they  shall  show  the  date,  amount,  when  due,  rate 
of  interest,  and  the  name  of  the  maker. 

Notes  receivable  are  sometimes  discounted.  This  happens  as 
a  rule  when  the  holders  are  unable  to  wait  for  the  notes  to  mature 
and  be  paid.  The  practice  is  sometimes  indulged  in  for  profit 
where  the  difference  in  interest  rates  is  sufficient  to  warrant  it. 
The  taking  of  notes  at  6%  and  discounting  them  at  4%  will,  if 
the  volume  of  transactions  is  sufficiently  great,  produce  quite  a 
tidy  sum  in  interest.  This  cause  of  notes  being  discounted  is  the 
exception,  probably,  rather  than  the  rule.  The  principal  reason 
for  discounting  them  is  usually  the  need  for  cash.    The  taking  of 

87 


Principles  of  Accounting 

a  note  from  a  customer  will  result  in  a  charge  to  notes  receivable 
and  a  credit  to  accounts  receivable.  If  later  the  note  is  dis- 
counted cash  will  be  charged,  and  off-hand,  it  may  appear  that 
notes  receivable  would  be  credited.  There  would  be  no  objection 
to  this  if  a  note  were  like  merchandise  and  the  transaction  were 
complete  with  the  passing  of  title.  In  the  case  of  a  note  the 
promise  of  the  customer  to  pay  is  supported  by  the  endorsement 
of  the  concern  which  discounts  it  and  in  the  event  of  the  custom- 
er's failure  to  pay  the  note  at  maturity,  the  bank  may  hold  the 
endorser.  The  possibility  of  such  an  event  occurring  makes  lia- 
bility in  connection  with  the  note  a  contingency.  Hence  we 
speak  of  the  contingent  liability  for  notes  receivable  discounted. 
Here  then  is  the  objection  to  crediting  notes  receivable  when 
cash  is  charged.  The  objectors  to  so  doing  contend  that  an 
account  called  notes  receivable  discounted  should  be  credited  to 
show  the  contingent  liability.  This  contention  in  turn  is  met  with 
the  objection  that  the  notes  physically  have  passed  out  of  the 
possession  of  the  company  and  will  in  nine  cases  out  of  ten  never 
again  come  into  the  possession  of  the  company.  As  a  compromise 
a  third  method  of  treatment  suggests  ignoring  each  of  the  above 
methods  in  part  and  making  mention  of  the  fact  that  they  are 
notes  receivable  discounted  and  outstanding,  with  the  amount 
thereof,  as  a  foot  note  on  the  balance  sheet. 

In  the  matter  of  showing  notes  receivable  discounted  on  the 
balance  sheet  there  is  a  choice  of  three  ways.  The  first  is  to 
include  on  the  right  hand  side  of  the  balance  sheet  among  the 
current  liabilities  an  item  for  notes  receivable  discounted,  giving 
it  the  effect  of  an  offset  to  the  notes  receivable  shown  on  the  left 
hand  side  among  the  current  assets.  The  second  way  is  to  with- 
draw from  the  current  assets  and  show  separately  on  the  asset 
side,  below  the  current  assets  the  amount  of  the  notes  receivable 
which  have  been  discounted,  referring  in  parentheses  to  the 
contra  account  on  the  opposite  side  of  the  balance  sheet  for  notes 
receivable  discounted,  which  item  will  appear  below  the  current 
liabilities.  Both  of  these  methods  have  the  effect  of  showing  the 
contingent  liability  in  the  balance  sheet  proper.  The  third  method 
is  to  exclude  from  both  the  assets  and  liabilities  the  notes  receiv- 
able discounted  and  refer  to  them  in  a  foot  note  at  the  bottom 
of  the  balance  sheet.  The  foot  note  might  read  as  follows :  "Con- 
tingent liability  for  notes  receivable  discounted  and  outstanding, 
$10,000." 


Current  Assets 

The  treatment  of  the  interest  involved  in  notes  receivable  dis- 
counted demands  some  little  attention.  To  illustrate  this  point  let 
it  be  assumed  that  there  is  received  from  the  customer  a  note  for 
$30,000,  due  in  90  days,  and  bearing  interest  at  6%.  The  interest 
on  such  a  note  would  amount  to  $450.  The  note  would  stand  on 
the  books  at  $30,000,  while  no  entry  would  be  made  until  the  end 
of  the  month  for  the  interest.  At  the  end  of  the  month  accrued 
interest  on  notes  receivable  would  be  charged  and  interest  on 
notes  receivable  credited.  If  the  notes  were  to  be  discounted 
after  45  days  had  elapsed  from  the  date  of  its  issue,  assuming 
that  the  discount  were  figured  by  the  interest  method  rather  than 
by  the  true  discount  method,  there  would  be  received  from  the 
bank  $30,225.  This  amount  is  really  divisible  into  three  parts, 
$30,000,  $150  and  $75.  While  the  total  of  the  three  would  be 
chargeable  to  cash,  $30,000  would  be  credited  to  the  notes  receiv- 
able account,  $150  to  the  account  for  accrued  interest  on  notes 
receivable  and  $75  to  the  interest  earned  on  notes  receivable. 

A  slight  variation  of  these  steps  would  result  if  the  note 
instead  of  bearing  interest  at  6%  were  to  have  the  amount  of 
interest  included  in  the  face.  Thus  upon  receipt,  notes  receivable 
would  be  charged  with  $30,450,  and  $30,000  would  be  credited  to 
the  customer  and  $450  to  the  interest  on  notes  receivable.  At  the 
end  of  the  month  interest  on  notes  receivable  would  be  charged 
and  interest  unearned  on  notes  receivable  credited  with  $300.  If 
as  in  the  preceding  instance  the  notes  were  discounted  15  days  later 
and  realized  $30,225,  cash  would  be  charged  with  $30,225,  notes 
receivable  would  be  credited  with  $30,225,  but  an  adjustment 
would  be  necessary  between  the  notes  receivable  account  and  the 
interest  unearned  on  notes  receivable  in  order  to  close  out  the 
diflference  remaining  in  the  notes  receivable  account  of  $225.  This 
could  be  most  easily  accomplished  by  an  entry  which  would 
charge  interest  unearned  on  notes  receivable  with  $300  and  credit 
notes  receivable  with  $225  and  interest  on  notes  receivable  with 
$75.  For  practice  purposes  complications  may  be  introduced  in 
both  of  the  above  mentioned  instances  by  taking  the  interest  on 
the  notes  at  one  rate  and  the  discount  at  another  rate.  It  is 
thought  that  sufficient  time  has  been  given  to  this  topic  so  that 
no  further  illustrations  on  this  point  will  be  indulged  in. 


89 


CHAPTER   XIV 

PATENTS,  COPYRIGHTS  AND  TRADEMARKS 

The  topics  suggested  by  the  subject  of  this  chapter  are  fre- 
quently considered  along  with  goodwill.  They  seem,  however, 
to  be  of  sufficient  importance  and  so  unlike  goodwill  as  to  warrant 
a  discussion  apart  from  that  subject.  It  frequently  happens  that 
where  a  concern  is  taken  over  by  a  corporation,  the  capital  stock 
issued  for  the  net  assets  of  the  concern  does  not  equal  the  value 
placed  upon  the  net  assets.  The  amount  of  capital  stock  may  be 
greater  or  less  than  the  net  assets.  Where  the  capital  stock  is 
smaller  in  amount  it  need  not  be  considered  for  the  purpose  of 
this  discussion.  Where  it  is  greater  it  will  give  rise  to  a  difference 
on  the  asset  side.  This  difference  may  be  absorbed  by  a  revalua- 
tion of  the  assets  but  it  is  frequently  termed  patents,  copyrights 
and  goodwill.  This  practice  is  to  be  censured  unless  such  assets 
■actually  exist  and  are  reasonably  worth,  in  the  opinion  of  the 
directors,  the  value  thus  assigned  to  them.  Goodwill  merits  sep- 
arate consideration  and  will  be  taken  up  later.  The  things  of 
interest  concerning  patents,  copyrights  and  trademarks  are  their 
nature,  how  much  they  are  worth  when  they  are  acquired, 
whether  or  not  they  may  increase  in  value  during  their  existence 
and  ho]^  long  they  may  be  carried  at  the  original  or  at  the  in- 
creased valuation. 

A  patent  is  an  instrument  issued,  by  the  federal  government 
through  its  patent  office,  to  an  inventor,  protecting  him  against 
the  possibility  of  having  some  other  person  make,  use,  or  offer 
for  sale  a  similar  device,  machine,  manufacturing  process,  or 
composition  of  matter.  Patents  are  issued  for  a  term  of  seven- 
teen years  and  may  not  be  renewed  except  by  an  act  of  Congress. 

A  copyright  is  an  instrument  issued  by  the  federal  govern- 
ment through  a  bureau  under  the  control  of  the  librarian  of 
Congress,  whereby  an  author  or  artist  is  granted  the  exclusive 
ri^bt  to  publish  and  dispose  of  his  work  for  a  limited  time.  A 
copyright  runs  for  twenty-eight  years  and  may  be  renewed  for 
a  period  of  twenty-eight  years. 

A  trademark  is  an  instrument  granted  by  the  federal  govern- 
ment to  citizens  of  the  United  States,  who,  by  registering  in  the 

90 


Patents,  Copyrights  and  Trademarks 

patent  office  certain  designs,  insignia,  symbols,  marks,  names,  or 
other  characteristic  indications  whereby  their  goods  are  identified 
and  advertised  for  sale,  are  protected  against  the  use  of  same  by 
others.  The  registering  of  a  trademark  carries  this  protection 
until  terminated  by  abandonment,  discontinuance  of  business,  or 
similar  manner. 

The  cost  of  securing  a  patent,  a  copyright,  or  registering  a 
trademark  is  nominal  and  bears.  ii9_relation  whatsoever  to  the 
value  of  either  of  these  forms  of  protection.  That  they  are 
"valuable  at  times  is  undisputed.  To  determine  their  value  is  a 
different  matter.  In  the  case  of  a  growing  concern  which  does  not 
contemplate  a  change  of  any  kind  it  may  be  perfectly  satisfactory 
to  carry  these  items  at  a  nominal  value  or  even  not  carry  them 
at  all.  If  a  change  in  the  ownership  is  about  to  take  place 
the  owners  will,  as  a  rule,  wish  to  place  a  value  upon  them.  It 
is  also  possible  that  even  when  no  such  change  in  ownership  is 
anticipated,  the  concern  owning  such  instruments  may  wish  to 
value  them.  There  are  two  means  of  accomplishing  this  pur- 
pose. One  is  to  place  an  arbitrary  value  upon  them.  The  other, 
which  is  the  more  scientific,  is  to  capilaJize  what  may  be  con- 
sidered as  excess  income,  or  the  income  attributable  to  these 
agencies.  For  example,  a  concern,  the  combined  capital  and  sur- 
plus of  which  is  $ico,ooo,  earns  $9,cxxD  per  year.  It  has  earned 
9%  upon  the  investment.  Assuming  that  6%  is  the  average  re- 
turn on  investment  in  the  line  of  business  in  which  the  concern 
in  question  is  engaged,  then  it  is  clear  that  there  is  excess  income 
of  $3,000,  which  is  to  be  attributed  to  some  cause  or  other  outside 
of  the  normal  agencies  which  produce  income.  If  there  are 
either  patents,  copyrights  or  trademarks  in  existence  and  in  use, 
what  would  seem  more  feasible  then  than  to  attribute  the  excess 
income  of  $3,000  to  the  possession  and  use  of  these  special  as- 
sets? On  this  theory  the  excess  income  is  capitalized  at  6% 
and  $50,000  set  up  as  the  value  of  the  special  assets  in  question. 

Irrespective  of  the  basis  used  in  valuing  patents,  copyrights 
and  trademarks,  a  valuation  once  placed  upon  such  assets  is 
subject  in  some  events  to  extraordinary  fluctuation.  Patents 
which  are  effective  today  may  be  so  closely  approximated  even 
without  infringement  within  a  short  time  as  to  render  the  pro- 
tective feature  almost  worthless.  In  a  corresponding  manner, 
copyrights  while  their  life  extends  over  a  considerable  number 

91 


Principles  of  Accounting 

of  years,  cover  as  a  rule  publications,  the  sale  of  which  is  limited 
and  soon  over.  Thus  while  the  sale  of  a  book  might  be  pro- 
tected for  forty-two-  years,  in  a  comparatively  short  time  in 
many  instances  there  is  nothing  to  protect.  The  value  of  trade- 
marks probably  continues  longer  and  with  greater  stability  than 
either  patents  or  copyrights.  However,  it  is  not  an  unusual 
thing  to  have  the  sale  of  an  article  damaged  by  a  similar  article, 
sometimes  with  a  trademark  just  sufficiently  different  so  as  not 
to  violate  the  law,  sometimes  with  a  different  trademark  when 
the  goods  are  of  a  cheaper  grade  or  quality  and  sometimes  when 
the  same  condition  exists  without  any  trademark.  For  these 
various  reasons  it  would  seem  that  if  assets  of  this  character 

vare  set  up  at  all,  they  should  be  written  down  either  gradually 
or  within  a  short  space  of  time.  Probably  no  exception  can  be 
taken  to  the  plan  of  writing  them  off  over  the  term  of  years 
specified  by  the  instrument,  but  it  would  certainly  seem  to  be 

j  ■'  better  policy  to  write  them  off  as  rapidly  as  possible  if  acquired 

u  by  purchase  and  to  carry  them  at  a  nominal  value  if  acquired  by 

'    issue. 

A  concern  which  acquires  patents  byj_ssue  has  a  choice  of 
valuing  them  and  carrying  them  in  three  different  ways.  They 
may  be  set  up  at  a  norninal  value  which  usually  means  carrying 
them  at  $i.oo,  at  an  arbitrary  value,  or  at  a  value  based  upon 
the  earning  pQiYjer.  Obviously  if  carried  at  a  nominal  value 
the  question  of  writing  them  down  does  not  arise.  If  they  are 
set  up  at  an  arbitrary  value  or  on  the  basis  of  their  earning  power, 
they  may  be  written  down  or  provision  made  for  their  depreciated 
value  over  a  period  of  seventeen  yoars.  This  theory  is  of  course 
based  on  the  fact  that  they  continue  in  force  and  effect  during 
this  period. 

A  condition  may  arise  here,  however,  which  is  analogous  in 
its  effect  to  that  which  a  new  machine  has  upon  depreciation.  The 
life  of  a  machine  may  be  fixed  at  twenty  years  and  arrangements 
made  to  provide  for  its  depreciation  over  that  period  of  time. 
If,  however,  the  type  of  machine  suddenly  becomes  obsolete  and 
is  replaced  by  a  machine  of  a  newer  type,  then  its  loss  in  value 
becomes  suddenly  great  and  the  net  value  which  is  in  reality 
its  book  value  less  what  it  is  worth  as  scrap  must  be  immediately 
written  off.  In  the  case  of  machinery,  however,  it  is  not  always 
the  scrap  value  which  is  taken  into  consideration  in  fixing  a 

92 


Patents,  Copyrights  and  Trademarks 

value  on  the  residue,  but  rather  its  value  as  a  second  hand  ma- 
chine. A  machine  which  would  be  obsolete  so  far  as  its  use 
in  the  United  States  Steel  Corporation  is  concerned  might  be 
valuable  to  some  manufacturing  concern  organized  on  a  smaller 
scale  and  doing  business  in  some  small  manufacturing  town. 
If  such  machines  were  sold  the  residual  value  would  be  the 
price  at  which  they  were  sold  rather  than  their  scrap  value, 
and  in  writing  them  off,  the  sale  price  rather  than  the  scrap 
value  would  be  the  amount  deducted  from  the  amount  to  be  writ- 
ten off. 

The  analogy  between  machines  and  patents  in  respect  to 
their  valuation  is  to  be  considered  only  up  to  a  certain  point.  A 
patent  may  be  effective  for  seventeen  years  or  it  may  become 
ineffective  or  partially  ineffective  as  a  protecting  agency  at  almost 
any  time.  Manufacturer  "A"  may  own  a  very  valuable  patent. 
It  may  entitle  him  to  make,  use,  or  sell  some  new  and  useful  ma- 
chine, manufacturing  process,  or  composition  of  material.  Manu- 
facturer "B"  may  appear  upon  the  scene  with  a  similar  design 
and  although  similar,  sufficiently  different  to  enable  him  to  se- 
cure a  patent  without  infringement,  which  device  may  be  so 
much  more  up-to-date  and  eagerly  sought  after  by  the  trade  as 
to  render  practically  valueless  the  patent  of  manufacturer  "A." 
Even  if  it  does  not  have  the  effect  of  destroying  the  value  of  the 
'first  mentioned  patent,  it  may  make  competition  so  keen  as  to 
modify  greatly  the  protective  benefits  which  formerly  accrued 
to  manufacturer  "A"  by  virtue  of  the  patent  which  he  held. 
Thus  having  carried  his  patent  either  at  an  arbitrary  value  or  at 
a  value  fixed  by  its  earning  power  he  is  confronted  with  having 
to  write  down  the  asset  either  wholly,  or  in  a  large  measure  de- 
pending upon  the  extent  to  which  the  value  of  his  patent  as 
such  has  been  impaired.  There  is  no  residual  value  in  this 
case  as  in  the  case  of  machines.  The  patent  has  no  value 
as  scrap  and  naturally  if  it  is  of  no  value  to  the  present  owner 
it  will  presumably  have  no  sales  value.  Thus  conservatism 
would  dictate  against  the  policy  of  attempting  to  carry  patents 
at  arbitrary  or  scientific  values  on  account  of  the  contingencies 
which  may  suddenly  arise. 

The  above  remarks  would  seem  to  be  equally  applicable  to 
copyrights  and  trademarks.  In  the  latter  case,  however,  there 
seems  to  be  less  possibility  of  these  contingencies  arising  and 

93 


Principles  of  Accounting 

stronger  arguments  in  favor  of  carrying  trademarks  at  other 
than  nominal  values. 

A  concern  which  purchases  or  acquires  patents,  copyrights  or 
trademarks  from  previous  owners  is  in  a  somewhat  different 
position.  Such  concerns  having  acquired  these  assets  in  exchange 
for  value  may  reasonably  argue  that  the  value  is  what  such 
assets  cost  to  acquire.  The  policy  of  writing  them  down  will 
depend  of  course  upon  the  judgment  or  desire  of  the  proprietor, 
but  the  period  over  which  the  depreciation  should  be  spread  will 
be  covered  in  the  respective  instances  by  the  life  of  the  instru- 
ment. Obviously  he  is  entitled  to  spread  the  depreciation  over 
the  life  of  the  respective  instrument,  but  the  conservative  pro- 
prietor will  write  them^  off  as  rapidly  as  the  business  permits 
in  order  to  insure  himself  against  any  contingencies  which  may 
detract  suddenly  from  the  value  of  the  assets. 

REFERENCES  FOR  COLLATERAL  READING! 

Patents  as  a  Factor  in  Manufacturing,  Prindle. 
Science  of  Accounts,  Bentley,  pages  199,  200. 
Accounting  Practice  and  Procedure,  Dickinson,  page  79. 
Auditing,  Theory  and  Practice,  Montgomery,  129,  130,  337. 
397. 


94 


CHAPTER   XV 

FRANCHISES 

A  franchise  is  an  instrument  granted  by  the  government  to 
individuals,  corporations,  or  other  types  of  legal  organization, 
giving  to  such  organization  the  exclusive  right  to  transact  specific 
lines  of  business  within  specified  limits  for  a  given  number  of 
years,  or  to  use  certain  natural  resources  of  the  country,  in  con- 
sideration of  certain  sums  of  money,  payable  either  all  at  one 
time  or  in  installments.  In  brief  a  franchise  is  a  contract  between 
the  government  and  some  legal  type  of  organization  covering  the 
above  mentioned  rights. 

Franchises  may  be  granted  by  the  federal  government,  the 
states,  counties  or  municipalities.  The  most  common  purposes 
for  which  franchises  are  granted  are  steam  railroads,  street  rail- 
roads, telegraph  and  telephone  systems,  water  systems,  gas  and 
electric  light  systems,  power  plants.  They  may  also  include  the 
rights  to  obstruct  water  ways  for  reservoir  purposes;  the  rights 
to  use  water  falls  and  in  fact  the  right  to  use  any  property  which 
the  government  owns. 

It  would  probably  not  be  wrong  to  include  among  the  fran- 
chise, rights  for  minor  purposes  such  as  the  use  of  the  streets 
for  vending  purposes  or  the  right  to  sell  merchandise  upon  the 
streets  or  from  house  to  house.  This  form  of  franchise  is  looked 
upon  in  a  different  manner  and  the  recipient  of  such  right  pays 
what  is  known  as  a  license.  The  privilege  conferred  upon  him 
in  return  for  the  tax  which  he  pays  is  of  a  restrictive  nature  as 
a  rule,  and  can  scarcely  be  considered  as  an  asset  since  such 
rights  are  usually  granted  to  all  persons  who  are  able  to  pay 
the  license  tax. 

The  distinguishing  feature  between  a  license  and  a  franchise 
would  seem  then,  to  be,  that  while  in  the  former  case  the  privilege 
is  granted  freely  to  all  who  apply;  in  the  latter  it  is  granted 
only  to  one  organization,  and  thereby  resembles  a  monopoly. 
By  virtue  of  having  acquired  a  monopoly  the  holder  thereof 
is  enabled  as  a  rule  to  make  larger  profits.  It  is  probable  that 
a  vendor  selling  knickknacks  on  the  street  would  not  consider  his 
license  as  an  asset.    He  would  more  properly  consider  it  as  ex- 

95 


Principles  of  Accounting 

pense  of  doing  business.  On  the  other  hand  a  street  raiiway 
company  holding  a  franchise  whereby  it  was  permitted  to  con- 
struct and  operate  a  system  of  tracks  and  cars  in  and  about  a 
given  city,  would  be  quite  justified  in  considering  the  franchise 
as  a  very  valuable  asset.  That  franchises  are  considered  as  val- 
uable assets  which  permit  the  holders  thereof  to  operate  to  the 
exclusion  of  all  others  is  evidenced  by  the  fact  that  a  tax  is 
imposed  upon  the  corporations  or  individuals  holding  them.  That 
it  is  difficult  to  determine  the  value  of  a  franchise  may  be  seen 
from  the  litigation  resulting  in  the  attempt  of  the  State  of  New 
York  to  impose  a  franchise  tax  upon  certain  corporations  operat- 
ing within  the  state. 

From  an  accounting  point  of  view  the  matter  of  valuation  is 
the  principal  point  to  be  considered.  If  the  franchise  is  ac- 
quired by  direct  grant  it  would  seem  that  the  matter  of  determin- 
ing its  value  should  be  decided  by  what  it  is  worth.  It  is  worth 
what  it  will  produce  in  the  way  of  excess  income.  Such  income 
it  would  seem  should  be  measured  by  the  monopoly  profits  which 
it  brings  in.  To  determine  the  monopoly  profits  is  to  compare 
the  total  profits  in  a  given  case  with  the  normal  average  profits  of 
a  similar  type  of  system. 

Assuming  in  a  given  case  that  the  net  assets  of  a  corporation 
owning  a  franchise  are  carried  at  $1,000,000,  such  net  assets 
being  represented  by  the  capital  stock  and  surplus,  and  produc- 
ing income  of  $300,000  per  annum.  It  may  be  further  assumed 
that  the  income  consistent  with  the  kind  of  organization  in 
question  is  10%,  or  $100,000.  Comparison  of  the  normal  profits 
with  the  profits  of  the  monopoly  shows  an  excess  of  $200,000, 
due  it  may  be  assumed,  to  the  franchise  which  the  company 
holds  and  which  amount  may  be  considered  as  the  monopoly 
profits.  If  the  profit  of  $200,000  is  due  to  the  fact  that  the 
company  holds  a  franchise,  then  apparently  the  franchise  is 
worth  what  it  will  produce  in  the  way  of  monopoly  profits  and 
should  be  capitalized  at  $2,000,000,  or  $200,000,  divided  by  10%. 

In  attempting  to  capitalize  a  franchise  in  this  manner  care 
should  be  taken  to  consider  any  amount  or  amounts  which  the 
company  has  paid  or  will  have  to  pay  for  the  franchise  and 
the  difference  only  in  any  case  set  up  as  the  value  of  the  asset. 
To  illustrate  this  it  might  be  supposed  in  the  above  mentioned 
case  that  the  company  paid  $150,000  for  the  franchise  at  the  time 

96 


Franchises 

it  was  acquired.  Under  such  conditions  the  $150,000  would  be 
excluded  from  the  net  assets  when  determining  their  amount  and 
in  view  of  the  fact  that  $150,000  would  probably  already  appear 
on  the  books  the  difference  only  between  such  an  amount  and  the 
new  amount  should  be  added.  As  used  above,  $1,850,000  would 
be  added  to  the  $150,000  appearing  on  the  books,  making  the 
book  value  $2,000,000.  If  for  example  the  company  were  to 
pay  $50,000  a  year  for  the  franchise  then  $50,000  should  be  de- 
ducted from  the  $200,000  before  capitalizing  it  at  10%,  so  that 
in  this  case  the  franchise  would  be  valued  at  $1,500,000. 

In  both  of  the  above  cases  the  element  of  time  appears  and 
should  be  taken  into  consideration  in  the  accounts.  A  franchise 
granted  for  any  time  less  than  perpetuity,  is  theoretically  a  wast- 
ing asset.  Its  value  would  be  affected  by  the  period  of  time 
for  which  it  is  granted.  It  is  quite  plain  that  a  franchise  granted 
for  ten  years  unless  renewable,  is  of  no  value  at  the  end  of  the 
tenth  year.  A  provision  therefore  should  be  made  for  depreciat- 
ing its  value  either  by  writing  it  down  or  through  the  medium  of 
a  reserve;  preferably  by  the  latter  method.  The  rapidity  with 
which  it  is  written  off  will  depend  upon  the  life  of  the  fran- 
chise. 

If  a  franchise  is  acquired  from  a  former  owner  the  matter  of 
its  valuation  may  differ  from  the  cases  above  referred  to.  Where 
acquired  by  purchase  rather  than  by  direct  grant  they  may  be 
carried  at  cost,  valued  as  above  indicated,  or  carried  at  an  arbi- 
trary value.  They  are  many  times  treated  the  same  as  patents, 
trademarks,  goodwill,  etc.,  and  made  to  represent  the  difference 
between  the  net  assets  of  the  old  concern  and  the  capital  stock 
of  the  new  concern.  This  is  to  be  objected  to  because  of  the 
reason  that  it  does  not  usually  represent  the  fact,  but  is  merely 
an  expedient  for  making  the  books  balance.  Under  any  cir- 
cumstance provision  should  be  made  for  depreciating  such  as- 
sets in  accordance  with  the  life  of  the  franchise. 

REFERENCE  FOR  COLLATERAL  READING  I 

Engineering  Value  of  Public  Utilities  and  Factories,  Foster, 
Chapter  XII. 


97 


CHAPTER  XVI    . 

GOODWILL 

In  discussing  goodwill,  it  will  be  necessary  to  say  something 
about  the  meaning  of  the  term.,  the  origin  of  goodwill,  its  valua- 
tion, its  duration  and  its  disposition. 

■  By  goodwill  is  meant,  that  intangible  possession  or  qualifica- 
tion which  is  capable  of  producing  recurring  income  or  by  virtue 
of  which  recurring  sales  may  be  made.  It  is  the  influence 
which  the  proprietor  or  his  organization  has  upon  the  purchas- 
ing public  through  which  he  is  enabled  to  attract  and  retain 
patronage.  In  some  cases  it  may  be  the  power  of  controlling 
certain  patronage.  It  is  that  peculiar  power  of  attraction  whereby 
the  proprietor  causes  the  buyer  to  seek  him  or  his  place  of  busi- 
ness when  in  the  market  for  the  kind  of  goods  which  the  pro- 
prietor has  for  sale. 

Goodwill  may  be  due  to  one  or  more  of  several  causes.  Pos- 
sibly the  manner  of  the  proprietor  or  his  sales  force  may  be 
pleasing.  Politeness,  patience  and  general  efficiency  on  the  part 
of  employees  are  important  factors  in  the  establishment.  The 
uniform  quality  of  goods,  variety  from  which  to  select,  and  the 
privilege  of  returning  goods  which  are  unsatisfactory  are  all 
things  which  appeal  to  many  customers  and  make  them  feel  kindly 
towards  the  merchant.  Honest  goods  and  honest  prices  have 
built  up  many  a  business.  Among  other  contributing  causes 
may  be  mentioned,  easy  terms,  attractive  display  of  goods,  at- 
tractive advertising,  a  level  of  prices  slightly  under  the  average, 
good  location,  facility  with  which  goods  may  be  found,  per- 
manent location  for  goods,  and  lastly,  general  reputation.  One 
of  the  oldest  and  largest  department  stores  in  New  York  City 
is  probably  not  only  losing  goodwill  but  gaining  ill-will  through 
a  recently  introduced  policy  of  frequently  shifting  goods  from 
one  part  of  the  store  to  another.  On  the  other  hand,  in  a  city 
like  New  York,  general  reputation  has  a  great  deal  to  do  with 
the  promotion  of  goodwill.  A  stranger  coming  to  New  York 
to  live  is  undoubtedly  influenced  by  a  friend  or  acquaintance  in 
favor  of  stores  which  have  reputations  for  certain  things.  Most 
housekeepers  in  New  York  will  tell  you  that  for  general  trading 

98 


Goodmll 

a  certain  Fifth  Avenue  store  is  unsurpassed,  while  for  muslins 
a  Fourteenth  Street  establishment  stands  at  the  head. 

Measuring  goodwill,  or  placing  a  value  upon  it,  is  a  much 
more  difficult  task  than  either  defining  it,  or  discussing  thejcaiises- 
underlying  its  creation.  The  occasions  for  valuing  it  are  prac- 
tically three:  to  reduce  the  rate  of  return  on  capital  investment; 
to  dispose  of  it  by  sale  or  consolidation;  to  give  a  proper  value 
to  an  established  business  before  the  admission  of  a  new  partner. 

In  connection  with  the  first,  a  proprietor  with  a  small  capital 
investment  might  by  means  of  goodwill  be  enjoying  profits  out 
of  proportion  to  his  nominal  investment.  The  ratio  of  return 
to  nominal  capital  might  be  abnormally  high.  For  business 
reasons  it  might  be  to  his  advantage  to  increase  his  capital  in 
accordance  with  the  goodwill  acquired  and  thus  decrease  the 
ratio  of  return  to  investment. 

In  the  same  manner,  a  corporation  might  find  it  advantageous 
to  reduce  the  apparent  return  on  its  capital  stock  by  setting  up 
goodwill  and  distributing  the  surplus  arising  therefrom  through 
a  stock  dividend. 

In  the  second  case,  a  concern  about  to  sell  out,  to  con- 
solidate with  another  concern  or  to  incorporate  may  very  justly 
and  reasonably  wish  to  capitalize  its  goodwill. 

In  a  similar  manner  a  concern  into  which  a  partner  is  about 
to  enter  will  undoubtedly  value  its  goodwill  before  coming  to 
an  agreement  with  the  new  partner  if  he  purposes  buying  an 
interest  in  the  business. 

As  to  the  methods  of  placing  a  value  upon  the  goodwill  in 
any  case,  it  must  of  course  be  admitted  that  in  many  instances 
the  figures  representing  it  show  price  instead  of  value.  Such 
price  may  be  fixed  at  what  it  is  expected  the  prospective  pur- 
chaser will  be  willing  to  pay.  This  is  not  placing  a  value  upon 
it.  There  are  two  scientific  methods  of  valuation  generally  in 
use.  They  are  widely  divergent  and  the  application  of  the 
two  methods  to  the  same  figures  produces  surprisingly  different 
results.  Both  have  as  their  basis  of  calculation  what  is  known 
as  the  excess  income. 

It  is  conceded  that  every  proprietor  receives  a  certain  normal 
share  of  trade  in  the  line  in  which  he  is  engaged.  The  normal 
share  is  assumed  to  be  that  which  will  yield  him  the  average 
return  on  his  investment.     The  average  return  for  the  line  of 

99 


Principles  of  Accounting 

business  in  question  is  perhaps  six  per  cent.    Any  excess  above 
6%  which  the  capital,  or  capital  stock  and  surplus,  will  produce 
is  attributed  to  goodwill. 

To  illustrate  the  first  method,  take  as  an  example  The  J  ones 
Manufacturing  Company,  engaged  in  the  retail  cloak  business 
with  a  capital  of  $i,ooo,ocx>.  Such  a  concern  might  be  imagined 
as  having  profits  of  $78,000  for  the  year.  By  net  profits  is 
meant  the  sum  available  for  distribution  as  dividends,  or  the 
amount  to  be  credited  to  surplus  after  every  known  charge  ex- 
cept dividends  has  been  deducted  from  the  income.  Ordinarily 
perhaps,  the  capital  would  be  expected  to  yield  but  $60,000.  The 
excess  of  $18,000  is  attributable  to  goodwill  and  the  capitaliza- 
tion of  this  amount  at  the  average  rate  of  interest  determines 
the  value  of  the  goodwill.  More  specifically  dividing  $18,000  by 
six  (6)  per  cent  gives  as  a  result  $300,000.  It  would  not  be 
advisable  to  use  for  this  purpose  the  excess  income  of  one  year, 
since  the  income  might  have  fluctuated  considerably.  The  aver- 
age excess  income  of  periods  extending  from  three  to  five  years 
would  seem  to  be  a  more  conservative  basis,  although  periods  less 
than  a  year  have  at  times  been  used. 

The  second  method  while  based  on  the  excess  net  income, 
proceeds  in  a  manner  quite  different  from  the  former  method. 
It  should  be  pointed  out  that  the  results  obtained  by  the  second 
method  would  theoretically  be  of  value  only  where  the  sale 
or  similar  disposal  of  goodwill  was  involved  and  would  not  serve 
as  a  basis  for  adjusting  the  rate  of  return  on  investment.  The 
factors  are,  an  estimated  excess  income,  recurring  annually  for 
an  estimated  number  of  years.  For  example,  in  the  case  of 
The  Jones  Manufacturing  Company,  the  excess  income  was 
$18,000.  If  it  might  be  estimated  that  the  goodwill  could  be 
sold  and  conserved  for  a  period  of  ten  years,  the  value  would 
appear  to  be,  ten  times  eighteen  thousand  dollars  (10  x  $18,000) 
or  $180,000.  This  conclusion  is  based  on  the  assumption  that 
the  goodwill  would  continue  to  yield  annually  for  a  period  of 
ten  years  an  excess  income  of  $18,000.  This  is  capitalizing, 
without  regard  to  interest,  by  what  is  known  as  the  years' 
purchase  method. 

As  a  means  of  valuing  goodwill  this  method  seems  funda- 
mentally wrong.  It  looks  too  much  like  valuing  the  estimated 
productivity  of  the  "hen  which  lays  the  golden  eggs"  without 

100 


Goodwill        :   ^  /%  I    li **{'••»;  •*•.*  • 

giving  any  attention  to  the  hen.  Who  would  think  of  saying 
that  the  value  of  a  twenty  year  gold  bond  of  $i,ooo  paying 
interest  at  6%  per  annum  was  $1,200,  because  there  were  twenty 
interest  payments  of  $60  each?  On  the  other  hand,  who  would 
say  that  the  value  of  a  piece  of  property  estimated  to  produce 
$600  per  year  for  the  next  five  years  was  $3,000?  Would  it  not 
be  more  logical  to  consider  such  a  piece  of  property  worth  $6,000 
since  real  estate  ordinarily  nets  10%  on  the  investment? 

If  the  method  were  allowed  to  pass  without  attack  from  this 
standpoint  it  should  be  criticized  unless  scientifically  applied. 
Such  application  would  consist  in  finding  the  present  worth  at 
x%  of  an  annuity  of  $18,000  for  ten  periods.  It  will  thus  be 
seen  that  at  6%  the  computation  would  give  as  the  value  of  the 
goodwill  an  amount  of  approximately  $132,481. 

The  duration  of  goodwill  is  a  variable  quantity.  To  fix  the 
time  during  which  it  will  continue  to  produce  excess  income 
is  a  difficult  task.  Without  a  change  of  ownership  even  it  may 
continue  or  it  may  dwindle  depending  upon  the  attention  which 
is  given  to  the  basic  factors  upon  which  it  was  built.  Under 
new  ownership  and  changed  conditions  it  may  be  conserved  and 
increase  in  value  or  it  may  be  lost  in  a  short  time.  The  chances 
that  its  value  will  not  diminish  are  greater  if  it  is  not  sold. 

In  case  of  sale  it  may  be  of  interest  to  note  its  treatment 
from  the  accounting  standpoint  of  both  the  vendor  and  vendee 
and  ultimately  its  disposition  by  both.  The  valuation  of  good- 
will having  been  placed  upon  it  previous  to  the  sale,  when  the 
deal  has  been  consummated  it  loses  its  identity  so  far  as  the 
vendor  is  concerned  and  becomes  merely  an  item  in  the  group 
of  assets  upon  which  the  selling  price  was  based.  That  portion 
of  the  amount  realized  on  the  sale  which  corresponds  to  the 
goodwill  would,  in  the  failure  to  raise  an  account  on  the  books 
of  the  vendor  for  goodwill,  appear  as  so  much  profit  arising 
in  connection  with  the  sale.  It  would  probably  more  nearly 
represent  the  facts,  in  the  case  of  a  corporation,  if  two  accounts 
were  to  be  created  on  the  books  of  the  vendor  prior  to  sale,  one 
for  goodwill,  which  would  be  debited,  another  for  capital  sur- 
plus, which  would  be  credited.  Subsequently  the  capital  sur- 
plus would  be  apportioned  to  stockholders,  whose  holdings  would 
then  represent  the  amount  which  each  should  receive  upon  dis- 
tribution of  the  proceeds  of  sale. 

lOI 


.  ♦;*"  :-t ;";'': :     *.  :'•,  Principles  of  Accounting 

The  vendee  Is  now  in  possession  of  an  asset  m  exchange 
for  which  he  has  parted  with  value.  No  matter  what  the  moral 
right  to  carry  accumulated  or  created  goodwill  prior  to  sale 
may  be,  obviously  he  is  entitled  to  show  it  on  his  books  and 
in  his  balance  sheet.  In  doing  so,  however,  he  is  morally  bound 
to  show  it  at  its  cost  to  him;  that  is  to  say,  at  the  value  fixed 
upon  it  by  the  terms  of  the  sale.  A  corporation  is  not  warranted 
in  setting  up  an  account  for  goodwill  which  represents  the  differ- 
ence in  value  between  the  net  assets  and  the  capital  stock.  For 
example,  in  a  case  where  physical  assets  at  an  appraised  value  of 
$90,000,  were  taken  over  subject  to  liabilities  of  $10,000  and 
capital  stock  in  the  amount  of  $100,000  was  issued  for  same,  the 
corporation  is  not  justified  in  charging  the  difference  of  $20,000 
to  an  account  called  goodwill  merely  for  convenience.  That  this 
is  frequently  done  may  be  seen  by  reference  to  the  balance  sheet 
of  almost  any  large  industrial  merger  where  such  accounts  as 
"patents,  goodwill  and  franchises"  or  "trademarks  and  goodwill" 
are  usually  to  be  found.  Such  practice  has  given  rise  to  a  dis- 
tinction being  made  as  between  real  and  nominal  goodwill,  or 
"fictitious"  goodwill,  as  the  latter  is  more  commonly  called.  Nom- 
inal goodwill  constitutes  one  of  the  elements  in  corporate  organi- 
zation, which  is  known  as  "water." 

As  to  the  disposition  of  goodwill  authorities  differ.  Most 
Americans  consider  it  as  an  asset  of  diminishing  value.  English 
authorities  are  divided  in  their  opinions;  some  of  them  favor 
writing  it  off  over  a  period  of  years;  others  advocate  its  con- 
tinuance at  the  cost  price  irrespective  of  fluctuations  in  its  value. 
It  is  to  be  borne  in  mind  that  it  may  appreciate  in  value  and  the 
question  arises  as  to  whether  or  not  it  should  be  revalued  an- 
nually. The  tendency  in  the  value  is  to  decline  and  the  safest 
policy  to  adopt  would  probably  be  to  make  provision  for  a  re- 
serve to  offset  the  item  of  goodwill,  the  annual  amount  of  the 
provision  depending  upon  the  number  of  years  which  the  most 
conservative  estimate  would  fix  as  its  life. 

REFERENCES  FOR  COLLATERAL  READING! 

Good-will  and  Its  Treatment  in  Accounts,  Dicksee  and  Till- 
yard. 

Accounting  in  Theory  and  Practice,  Lisle,  page  134-135. 

Accounts,  Their  Construction  and  Interpretation,  Cole,  pages 
276-280,  307-310. 

Modern  Accounting,  Hatfield,  Chapter  VI. 

Auditing,  Theory  and  Practice,  Montgomery,  pages  131,  338- 


Funds 


CHAPTER   XVII 

FUNDS 

A  fund  should  without  exception  be  understood  to  mean  an 
asset.  We  think  about  funds  as  meaning  cash,  but  we  can 
no  more  say  that  all  funds  are  cash  than  that  all  cash  belongs 
to  funds  except  with  the  introduction  of  the  qualifying  state- 
ment that  cash  as  we  have  come  to  look  upon  it  in  connection 
with  the  balance  sheet  is  a  general  fund  available  for  the  pur-, 
poses  of  the  business.  —-^ 

Funds  are  not  reserves.    A  reserve  is  never  a  fund.      A  re- 
serve may  be  created  for  the  purpose  of  measuring  or  controlling 
a  fund,  but  it  is  always  in  the  nature  of  an  accountability.   Funds 
should  always  be  on  the  left  hand  side  of  the  balance  sheet.] 
Reserves  except  when  treated  as  deductions  should  be  on  ^e " 
right  hand  side  of  the  balance  sheet.     A  fund  is  sometimes  de- 
scribed as  a  reserve  fund,  and  in  fact  by  some  people  it  is  given 
the  erroneous  name  reserve.     A  fund  may  be  set  aside  for  certain 
purposes  designated  by  a  reserve.     This  operation  is  sometimes 
known  as  the  funding  of  a  reserve.     This,  however,  does  not 
have  the  effect  of  making  it  a  reserve. 

The  point,  however,  upon  which  emphasis  is  to  be  placed  is 
that  funds  are  always  assets.  They  may  be  classified  as  general 
funds  and  special  funds.  When  used  in  the  first  sense,  cash  in 
hand  or  on  deposit  and  available  for  general  purposes,  or  unre- 
stricted cash,  is  meant.  In  the  second  instance  the  meaning 
is  the  exact  opposite.  A  special  fund  emphatically  denotes  that 
such  funds  are  not  available  for  the  general  purposes  of  the 
business  and  are  sacred  to  the  purposes  for  which  they  were 
set  aside.  It  is  true  of  course  that  when  the  purpose  for  which 
they  were  intended  has  been  accomplished,  any  balance  remaining 
may  be  transferred  back  to  the  general  cash,  whence  it  pre- 
sumably came.  The  use  of  the  term  special  fund  is  not  intended 
to  include  such  items  as  working  funds  or  petty  cash  funds,  these 
representing  merely  the  setting  aside  for  convenience  of  a  por- 
tion of  the  general  cash.  The  classification  does  embrace,  how- 
ever, sinking  funds,  special  funds  such  as  were  set  aside  by  the 
gas  companies  in  compliance  with  the   ruling  of  the  court  in 

103 


Principles  of  Accounting 

the  matter  of  80  cent  gas,  pension  funds,  emergency  funds  for 
accidents  and  illness  of  employees,  insurance  funds  and  con- 
tingent funds,  etc. 

The  basis  upon  which  funds  are  created  will  depend  upon 
the  circumstances.  At  times  they  may  be  accumulated  by  the 
arbitrary  setting  aside  of  fixed  amounts  periodically.  They  may 
be  accumulated  by  the  setting  aside  of  arbitrary  amounts  varying 
in  size  from  time  to  time.  They  may  be  created  by  setting  aside 
a  fixed  sum  for  a  given  purpose  like  the  amortization  of  some 
indebtedness,  as  in  the  case  of  a  sinking  fund  for  the  purpose  of 
paying  off  bonds  at  maturity,  where  the  terms  governing  the  set- 
ting aside  of  the  sum  are  prescribed  by  the  instrument  of  indebt- 
edness. 

In  cases  like  the  emergency  fund  and  contingent  fund  above 
mentioned  it  is  probable  that  the  amounts  would  be  set  aside 
spasmodically  or  at  the  convenience  of  the  business.  Funds  such 
as  the  public  service  gas  fund  would  be  regulated  by  the  rapidity 
with  which  collections  were  made  from  customers.  Such  a 
fund  would  accumulate  automatically.  Insurance  funds  would 
probably  be  set  aside  semi-annually  or  annually  and  the  amount 
would  be  determined  by  the  premiums  which  the  concern  would 
be  obliged  to  pay  to  the  insurance  company  in  order  to  carry 
adequate  insurance  on  the  property.  Sinking  funds  on  the  other 
hand  would  accumulate  by  the  setting  aside  periodically  of  fixed 
amounts,  sometimes  monthly,  sometimes  quarterly,  sometimes 
semi-annually  and  sometimes  annually.  The  periods  and  amounts 
are  usually  fixed  by  the  mortgage  which  secures  the  bond.  The 
sinking  fund  deposit  might  be  determined  by  the  term  of  the 
bond  and  the  amount  necessary  to  liquidate  the  liability  at  ma- 
turity prorated  over  the  life  of  the  bond.  Another  manner  of 
accumulating  the  sinking  fund  is  to  set  aside  semi-annually  or 
annually  such  a  sum  as  will  at  compound  interest  amount  at 
maturity  to  the  face  of  the  bond. 

In  all  cases  where  funds  are  involved  there  is  also  the  ques- 
tion of  interest.  The  question  becomes  one  of  whether  the 
interest  attaches  to  the  fund  or  to  the  general  cash,  thereby 
becoming  available  for  general  purposes.  The  earnings  from 
funds  are  usually  credited  to  income.  The  alternative  is  to 
credit  them  to  a  reserve  account.  If  they  are  credited  to  income 
it  has  the  effect  of  making  the  complementary  asset  available  for 

104 


Funds 

general  purposes.  If  they  are  treated  as  a  reserve  it  prevents 
the  use  of  the  asset  for  current  purposes.  In  the  case  of  straight 
funds,  it  is  thought  to  be  better  unless  otherwise  provided  to 
credit  the  income  from  the  funds  to  the  operations  and  make 
the  interest  received  available  for  general  use.  Where  the  in- 
terest received  is  to  be  made  a  part  of  the  new  deposit  for  sinking 
fund  purposes,  obviously  the  income  should  be  credited  to  a  re- 
serve. The  effect,  however,  is  the  same  as  creating  a  reserve  for 
a  sinking  fund  out  of  earnings,  since  such  reserves  ultimately 
revert  to  the  surplus. 

To  illustrate  the  creation  of  sinking  funds  by  the  scientific 
method  and  show  the  relation  which  the  interest  earning  bears, 
let  it  be  assumed  that  the  American  Cigar  Company  issued  on 
January  ist,  1908,  bonds  to  the  amount  of  $1,000,000,  payable 
January  1st,  1910,  with  interest  at  6%,  payable  semi-annually. 
Let  it  be  further  assumed  that  the  bonds  provide  for  a  sinking 
fund  to  be  accumulated  by  semi-annual  deposits  for  the  purpose 
of  liquidating  the  bonds  at  maturity  and  that  the  interest  allowed 
by  the  depository  on  sinking  fund  deposits  is  2%.  The  two 
questions  which  present  themselves  are,  first,  what  amount  shall 
be  deposited  in  the  sinking  fund  semi-annually,  and  second,  what 
disposition  shall  be  made  of  the  earning  which  attaches  to  the 
interest  on  the  sinking  fund  deposits. 

The  amount  to  be  accumulated  for  liquidation  purposes  is 
$1,000,000.  The  periods  involved  are  four,  since  the  deposits  are 
made  semi-annually.  With  regard  to  the  sinking  fund  payments, 
there  must  first  be  determined  what  amount  or  annuity  must  be 
deposited  at  the  end  of  each  period  of  six  months,  so  that  at  the 
end  of  two  years  the  accumulation  of  deposits  and  the  interest 
thereon  will  amount  to  $1,000,000.  No  attempt  will  be  made 
herein  to  explain  the  formula  whereby  the  proper  amount  is 
arrived  at,  since  tables  showing  the  amounts  are  always  available 
for  use.  If  information  as  to  the  formula  is  desired,  Sprague's 
tables  of  compound  interest  may  be  consulted.  These  tables  show 
that  the  amount  to  be  deposited  at  the  end  of  each  of  the  four 
periods  is  $242,623.75.  This  amount  if  deposited  four  times 
would  result  in  an  aggregate  of  $970,495.  This  noticeably  is 
less  than  $1,000,000,  and  the  difference  of  $29,505  is  presumably 
made  up  of  the  interest  on  the  deposits.  The  first  question  which 
will  probably  arise  in  the  mind  of  the  reader  is  whether  the  de- 

105 


Principles  of  Accounting 


posits  begin  on  January  ist,  1908,  or  on  June  30th,  1908,  and  in 
order  to  have  this  clearly  established  a  study  of  the  following 
computations  will  prove  beneficial. 


$242,623.75 
.02 

$4,852.4750 
242,623.75 

$247,476.2250 
242,623.75 

$490,099.9750 
.02 

$9,801.999500 
490,099.975 

$499,901.974500 
242,623.75 

$742,525.724500 
.02 

$14,850.51449000 
742,525.7245 

^757»376.  23899000 
242,623.75 

$999,999 .  98899000 

Interest 

$4,852,475 
9,801.9995 
14,850.51449 

$29,504.98899 


First  deposit,  June  30,  1908 
Interest  to  January  i,  1909 


Fund,  January  i,  1909 

Second  deposit,  January  i,  1909 


Interest  to  June  30,  1909 


Fund,  June  30,  1909 

Third  deposit,  June  30,  1909 


Interest  to  January  i,  19 10 

Fourth  deposit,  January  i,  19 10 
Fund,  January  i,  19 10 
Deposits 
$242,623.75 


$970,495.00 


Deposits $970,495 . 

Interest 29,504 .  98899 

Fund $999,999 .  98899 

From  the  above  it  will  be  noted  that  the  first  deposit  was  on 
June  30,  1908.      The  amount  deposited  at  that  time  bore  interest 

106 


Funds 

at  the  rate  of  2%  from  June  30,  1908,  to  January  i,  1909,  at 
which  time  there  was  added  to  the  original  deposit,  a  second 
deposit  in  a  similar  amount  and  the  interest  for  the  six  months 
just  past.  The  aggregate  of  these  amounts  then  became  a  new 
principal,  which  in  turn  bore  interest  at  2%  for  the  six  months 
ended  June  30,  1909,  and  so  on  throughout  the  period  of  time 
covered.  If  the  various  amounts  of  interest  which  accrued  on 
the  deposits  are  segregated  from  the  computation  they  will  be 
seen  to  amount  to  $29,504.98  and  a  fraction,  which  practically 
agrees  with  the  amount  of  interest  determined  by  deducting  four 
times  the  sinking  fund  deposit  from  $1,000,000. 

The  fund  it  will  be  noticed  was  derived  from  two  sources, 
one  the  general  cash  of  the  company,  the  other,  the  interest  paid 
by  the  depository.  The  deposits  made  by  the  company  were 
charged  to  the  sinking  fund  and  credited  to  general  cash.  The 
interest  was  reported  by  the  sinking  fund  simultaneously  with  a 
credit  to  an  interest  earned  account.  The  disposition  of  the 
interest  earned  account  now  becomes  the  subject  for  discussion. 
There  are  of  course  three  possibilities. 

The  first  is  to  take  it  into  the  earnings  of  the  company  as 
other  income.  This  procedure  seems  objectionable  because  of 
the  reason  that  the  cash  corresponding  to  the  earning  is  included 
in  the  sinking  fund  and  on  account  of  being  applied  in  part 
to  the  liquidation  of  the  bonds  outstanding  it  is  not  available  for 
general  disbursement. 

The  second  possibility  is  that  of  crediting  it  to  a  reserve  ac- 
count for  interest  on  sinking  fund.  This  account  would  grad- 
ually accumulate  a  credit  balance  until  at  the  end  of  the  second 
year  it  showed  $29,505.  At  the  time  the  bonds  were  liquidated 
the  reserve  would  apparently  be  liberated  and  would  revert  to 
surplus.  Thus  it  is  difficult  to  see  what,  if  any,  purpose  has  been 
accomplished  by  accumulating  this  reserve. 

The  third  possibility  is  that  of  crediting  the  interest  earned  to 
the  interest  paid  account.  It  is  to  be  remembered  that  these 
bonds  bore  interest  at  the  rate  of  6%.  In  other  words,  the  com- 
pany paid  for  the  use  of  $1,000,000  for  a  period  of  two  years, 
$120,000.  By  virtue  of  having  put  aside  in  a  sinking  fund  stipu- 
lated amounts  from  time  to  time,  the  company  has  been  deprived 
of  the  use  of  the  money,  which,  however,  has  earned  $29,505. 
It  would  thus  appear  that  the  expense  to  the  company  for  the 

J  07 


Principles  of  Accounting 

proceeds  of  the  bonds  actually  available  for  use  should  be  de- 
termined by  an  amount  representing  the  difference  between  the 
interest  paid  on  the  bonds  and  interest  received  on  such  funds. 
If  this  application  of  the  earnings  were  made  to  the  interest  paid 
for  the  use  of  the  money,  the  expense  to  the  company  would 
be  $90,495.  This  last  method  it  must  be  admitted  seems  the 
more  logical  and  equitable. 

The  relation  of  sinking  funds  to  reserves  will  be  discussed  in 
the  chapter  dealing  with  reserves. 

REFERENCES  FOR  COLLATERAL  READING! 

Accounts,  Their  Construction  and  Interpretation,  Cole,  pages 
87-89. 

Science  of  Accounts,  Bentley,  pages  178-180. 

Auditing,  Theory  and  Practice,  Montgomery,  page  136. 

Accounting  Practice  and  Procedure,  Dickinson,  page  148. 

Journal  of  Accountancy,  Vol.  VI,  pages  394-439;  Vol.  VII, 
pages  58,  185,  406. 

Modern  Accounting,  Hatfield,  Chapter  XIV. 


108 


CHAPTER   XVIII 

DEFERRED   CHARGES   TO   EXPENSE 

The  items  in  this  group  are  variously  referred  to  as  deferred 
assets,  deferred  debits,  deferred  charges  to  operations  and  de- 
ferred charges  to  expense.  They  have  also  been  referred  to  as 
"assets  by  courtesy."  Rather  more  stress  should  be  laid  on  the 
nature  of  these  items  and  their  significance  than  the  name  by 
which  they  are  designated.  If  we  are  to  be  precise  we  shall 
probably  call  them  deferred  charges  to  expense,  since  this  term 
seems  most  accurately  to  describe  them.  They  are  expense  items 
wherein  the  act  of  charging  them  to  expense  accounts,  which 
accounts  will  be  in  turn  closed  out  to  profit  and  loss,  has  been 
deferred  to  a  subsequent  period  giving  to  them  the  effect  of  as- 
sets. This  group  comprises  insurance,  taxes,  rent,  advertising, 
organization  expense,  development  expense,  moving  expense,  etc. 

It  is  quite  usual  to  look  upon  these  items  as  in  the  nature  of 
prepaid  expenses.  They  may  be  prepaid  in  many  cases.  How- 
ever, it  should  be  pointed  out  that  the  matter  of  prepayment  does 
not  enter  into  the  proposition.  They  are  to  be  considered  as 
assets  if  the  corresponding  liability  has  been  taken  up  whether 
or  not  it  has  been  paid.  There  is  no  uniform  rule  for  handling 
them,  neither  is  there  any  uniform  rule  for  writing  them  off.  In 
some  instances  such  as  insurance,  taxes,  rent  and  advertising,  the 
period  which  they  cover  is  defined.  In  other  cases  such  as  or- 
ganization and  development  expenses  the  period  covered  is  unde- 
fined and  must  be  arbitrarily  fixed.  They  are  usually  pro- 
rated over  a  period  of  time,  but  there  are  cases  where  their  valua- 
tion is  governed  by  circumstances  such  as  whether  the  concern  in 
question  is  a  going  concern  or  one  about  to  be  wound  up. 

There  are  two  ways  of  handling  deferred  charges  to  expense. 
One  is  to  provide  in  each  case  two  accounts,  one  for  assets  and 
one  for  the  expenses,  and  sometimes  a  third  account  for  the 
reserve.  At  the  time  of  closing  the  books  the  asset  account  is 
either  written  down  to  the  expense  account  or  the  expense  ac- 
count charged  and  the  reserve  account  credited.  The  other 
method  consists  in  treating  them  as  the  expense  accounts.  At 
closing  time  the  balance  of  the  unexpired  assets  is  treated  as 

109 


Principles  of  Accounting 

an  inventory  and  applied  to  the  expense  account  thereby  convert- 
ing it  into  an  asset  through  the  inventory,  which  is  brought  down 
while  the  balance  in  the  account  is  closed  out  to  profit  and  loss. 
The  first  named  method  is  the  clearer  of  the  two  and  is  to  be 
preferred.  It  is  clean  cut  at  all  times  and  greatly  facilitates  effi- 
cient work. 

With  regard  to  insurance  the  amount  shown  as  the  asset  is 
the  premium  on  the  policy.  It  matters  not  whether  the  pre- 
mium has  been  paid  so  long  as  the  invoices  for  same  have  been 
received  and  the  amount  is  included  among  the  liabilities.  Here 
the  period  covered  is  defined  by  the  policy.  It  may  be  for  three 
years,  or  for  one  year  or  a  shorter  period  of  time.  Arrangements 
should  be  made  to  write  off  the  premium  over  the  life  of  the 
policy  charging  to  each  period's  operations  or  expenses  its  pro- 
rata share.  For  example,  if  on  January  ist  a  company  insures 
some  of  its  property  and  the  premium  on  the  policy  is  $1,200, 
there  should  be  charged  off  to  expense  each  month  $100.  It 
is  not  customary  in  the  case  of  insurance  to  create  a  reserve. 
The  preferable  method  is  to  charge  expense  or  insurance  and 
credit  insurance  premiums  or  unexpired  insurance  as  the  title 
of  the  account  appears. 

The  procedure  is  comparatively  simple  in  the  ideal  case  just 
mentioned.  It  would  become  somewhat  more  complex  when 
there  are  a  great  many  policies  in  force  covering  different  periods 
and  maturing  at  different  dates.  There  is  not  much  help  for 
this  complication  if  the  company  closes  its  books  monthly,  quar- 
terly or  semi-annually,  but  it  may  be  avoided  if  the  books  are 
closed  but  once  a  year  by  arranging  to  have  policies  written  for 
one  year  or  fractions  thereof  and  having  them  all  expire,  for 
example,  on  the  31st  of  December.  This  last  mentioned  practice 
is  somewhat  helpful  even  when  policies  are  written  for  periods 
greater  than  a  year. 

In  many  concerns  the  question  of  insurance  is  of  sufficient 
importance  and  the  policies  so  numerous  as  to  warrant  the  keep- 
ing of  an  insurance  register  wherein  the  policies  are  entered  with 
their  descriptions  and  columns  are  provided  so  that  the  amount 
of  the  premium  can  be  prorated  and  the  amount  corresponding 
to  each  month  shown  in  the  appropriate  column.  Thus  it  be- 
comes possible  to  determine  by  footing  up  the  various  columns 
the  amount  for  all  premiums  chargeable  to  expense  each  month. 

iio 


Deferred  Charges  to  Expense 

Care  must  be  exercised  in  this  as  in  other  cases  to  see  that 
cancellation  and  return  premiums  are  properly  prorated  and 
deducted.  This  is  very  often  accomplished  by  using  red  ink  and 
making  the  entries  either  above  or  below  the  original  entries. 

The  question  of  cancellation  brings  to  mind  the  basis  upon 
which  such  cancellations  are  made.  A  premium  of  $i,2CX)  cover- 
ing insurance  for  a  year,  if  cancelled  at  the  end  of  six  months  will 
not  result  in  a  refund  of  $600,  although  such  would  seem  reason- 
able. The  insurance  company  considers  that  it  is  entitled  to  a 
higher  premium  for  carrying  a  policy  six  months  than  for  carry- 
ing it  a  year.  Accordingly  if  a  policy  as  above  mentioned  were 
cancelled  at  the  end  of  six  months  the  company  would  only 
allow  what  is  termed  the  short  rate,  and  which  in  the  case  of 
the  policy  in  question  would  be  $360.  Short  rate  tables  are 
issued  by  the  National  Board  of  Fire  Underwriters  and  show 
the  short  rates  on  amounts  from  $i.(X)  to  $1,000  for  periods 
up.  to  twelve  months. 

The  question  may  be  asked  after  the  above  statements,  "Is  it 
proper  and  consistent  to  carry  the  unexpired  insurance  on  the 
pro-rata  basis?"  The  point  is  perhaps  debatable.  If  it  is  true 
that  after  one-half  the  period  covered  by  the  premium  has  ex- 
pired the  company  will  not  return  the  other  one-half  if  the 
policy  is  cancelled,  then  the  unexpired  proportion  would  seem 
not  to  be  worth  one-half  of  the  amount  paid,  but  a  somewhat 
smaller  amount.  In  order  to  substantiate  this  valuation  it  is 
necessary  to  introduce  the  everlasting  hypothetical  question, 
"what  would  the  policy  be  worth  if  the  company  were  to  cancel 
it?"  Were  the  "if"  in  this  case  to  be  considered  the  policy 
should  undoubtedly  be  valued  on  a  short  rate  basis.  In  view  of 
the  fact  that  the  company  expects  to  use  the  insurance  and  not 
cancel  the  policy,  the  expense  of  the  policy  will  be  proportionately 
less  on  account  of  the  long  time  and  the  unexpired  proportion 
worth  more.    Practice  dictates  the  use  of  the  latter  method. 

There  is  one  exception  to  the  foregoing  rule  of  which  cog- 
nizance should  be  taken.  It  will  be  noticed  that  mention  was 
made  in  the  preceding  paragraph  of  the  fact  that  the  company 
expected  to  make  use  of  the  insurance,  which  reason  was  given 
for  justifying  the  prorating  of  the  premium.  Where  a  concern 
is  in  bankruptcy  or  about  to  go  into  liquidation  or  any  situation 
arises  in  which  the  unexpired  insurance  will  not  be  used,  then 

III 


Principles  of  Accounting 

the  unexpired  proportion  might  very  properly  be  valued  on  the 
short  rate  basis. 

The  amount  of  premiums  paid  by  companies  carrying  large 
amounts  of  insurance  becomes  so  great  at  times  as  to  warrant 
their  taking  the  risk  themselves  and  instead  of  paying  the  pre- 
miums to  the  insurance  companies  depositing  them  in  a  fund  out 
of  the  accumulations  of  which  any  replacements  of  property 
destroyed  by  fire  may  be  made.  This  has  the  effect  of  carrying 
the  risk  instead  of  placing  it  upon  an  insurance  company  and 
is  often  practicable  where  the  possibility  of  destruction  through 
fire  is  small.  It  means  many  times  a  saving  of  money  to  the 
company  and  the  procedure  may  be  a  highly  successful  one. 
There  is  always  the  danger,  however,  of  a  conflagration,  in  which 
case  it  will  be  wished  with  regret  that  the  property  had  been 
insured  in  a  company  able  to  stand  the  loss. 

There  is  not  much  to  be  said  concerning  taxes  and  rent. 
They  are  understood  to  be  items  either  paid  in  advance  or  the 
liability  for  which  has  been  acknowledged.  They  should  be 
written  down  over  the  period  which  they  cover.  'Care  should 
be  taken  in  the  case  of  taxes  to  observe  the  effect  which  the 
tax  bill  has,  at  the  time  of  its  receipt,  upon  the  expense  and 
accrual  accounts. 

Assuming  a  tax  bill  amounting  to  $600  for  the  year  ended 
December  31    to   have  been   received  on  the    15th  of   October 
and  to  have  been  entered  in  the  voucher  register  but  unpaid 
at  October  31st.       If  the  taxes  had  been  accrued  monthly  on 
the  basis  of  $6cx),  upon  closing  the  books  at  October  31st  there 
would  have  been  charged  to  the  expense  account  for  taxes  $500 
and  a  credit  in  an  equal  amount  made  in  the  taxes  accrued.    The 
question  may  now  be  asked,  how  should  the  tax  bill  be  treated 
in  the  books  at  October  31st?    Taxes  for  the  year  are  due  the 
first  week  in  October,  therefore  if  the  bill  is  taken  up  for  the 
full  amount,  taxes  for  two  months  will,  at  October  31st,  have 
been  for  all  practical  purposes  prepaid.       Without  question  the 
liability  will  be  $600,  and  the  prepaid  proportion  will  amount  to 
$100.      If  the  bill  for  $600  were  to  be  charged  to  taxes  paid  in 
advance  and  credited  to  accounts  payable  there  would  be  a  double 
liability  by  virtue  of  the  fact  that  $500  had  already  been  accrued. 
To  prevent  this  possibility  when  the  credit  for  $600  was  made  to 
accounts  payable  the  charge  should  be  divided;  $500  should  be 

112 


Deferred  Charges  to  Expense 

charged  to  taxes  accrued  and  $ioo  to  taxes  paid  in  advance.  Sub- 
sequent to  October  31st  the  account  for  taxes  paid  in  advance 
should  be  written  down  to  taxes  in  equal  monthly  installments. 

Advertising  is  somewhat  different  from  the  above  mentioned 
items.       The  question  to  be  decided  and  which  bears  on  the 
writing  down  of  the  asset  seems  to  be  the  rapidity  with  which 
the  advertising  is  used  rather  than  the  period  covered.     A  con- 
cern which  paid  for  advertising  in   advance  to  the  extent  of 
$96  would  be  justified  in  carrying  that  amount  as  an  asset  until 
the  advertising  was  used.     The  fact  that  the  period  covered  by 
the  contract  was  a  year  would  have  no  bearing  on  the  matter. 
It  is  true  that  the  copy  might  be  spread  over  a  year  in  twelve 
numbers,  in  which  case  one-twelfth  of  the  amount  paid  would  be 
written  off  monthly.    If,  on  the  other  hand,  the  $96  was  for  one 
page  of  space  there  would  be  no  reason  why  the  amount  should 
be  written  off  except  as  space  up  to  one  page  was  used.     In 
any  of  these  cases  the  entry  would  consist  in  charging  advertising 
expense  and  crediting  advertising  prepaid. 

Organization  expense  and  development  expense  are  of  much 
the  same  nature.  A  pile  of  bricks  lying  by  the  side  of  the  road 
has  not  much  significance.  If  an  architect  draws  plans  for  a 
house  and  the  bricks  through  the  application  of  careful  plan- 
ning and  labor  are  worked  into  a  house,  there  will  not  be  much 
question  about  the  propriety  of  charging  to  the  cost  of  the 
house  the  fee  that  is  paid  to  the  architect  for  preparing  the 
plans  and  supervising  the  work  of  construction.  Neither  will 
the  expense  of  directing  the  labor,  organizing  and  superintending 
the  work  of  construction  be  objected  to  as  not  properly  included 
in  the  cost.  All  of  these  items  have  added  to  the  value  of  the 
bricks.  As  component  parts  none  of  the  elements  were  worth 
as  much  as  when  they  became  organized  into  a  structure. 

Similarly  there  is  no  reason  why  the  expense  of  organiz- 
ing a  corporation   or  any  other  company   should  be  objected 
to  as  not  adding  value  to  the  organization.      The  benefits  to 
be  derived  from  the  organization  of  a  corporation  extend  over 
a  period  of  years.     The  benefits  do  not  inure  entirely  to  the 
first  year.    It  may  almost  be  said  that  they  extend  over  the  life 
of  a  charter  in  the  case  of  a  corporation.     There  is  no  fixed 
rule  as  to  the  extent,  nor  is  there  any  fixed  rule  as  to  the  term 
of  years  over  which  they  should  be  spread.    Ultra-conservative 

"3 


Principles  of  Accounting 

corporations  where  the  profits  immediately  after  organization  are 
large,  charge  them  off  against  the  first  year's  profits  in  order  to 
be  rid  of  them.  Other  organizations  spread  them  over  a  period 
of  five  years;  some  over  ten  years  and  some  even  as  long  as 
twenty  years.  It  is  probable  that  ten  years  is  the  average.  Or- 
ganization expenses  will  consist  of  various  items,  such  as  com- 
pensation and  expenses  of  officers  or  stockholders  prior  to  in- 
corporation ;  legal  and  other  expenses  incident  to  the  organization. 
The  account  sometimes  includes  the  bonus  paid  to  promoters. 
The  amount  as  ultimately  determined  should  be  written  down 
over  the  term  fixed  by  the  officers  or  directors,  by  charging  or- 
ganization expense  written  off  and  crediting  organization  expense. 
The  same  thing  can  be  accomplished  by  charging  organization 
expense  written  off  and  crediting  reserve  for  organization  expense. 
The  latter  is  perhaps  to  be  chosen  because  of  the  fact  that  it  per- 
mits the  original  asset  to  stand,  thus  showing  at  all  times  what 
the  expense  of  such  organization  was.  When  the  reserve  equals 
the  asset  one  may  be  closed  out  against  the  other  if  desired. 

Development  expense  is  usually  found  in  connection  with 
mining  companies  where  it  is  treated  in  a  manner  similar  to  that 
described  above  in  connection  with  organization  expense. 

Moving  expense  is  sometimes  found  as  a  deferred  charge. 
This  may  happen  where  it  becomes  advisable  for  a  plant  to  move 
from  one  place  to  another  and  it  is  thought  that  the  benefits 
resulting  from  the  change  of  location  are  sufficiently  great  to  war- 
rant the  expense  thereof  being  charged  to  a  deferred  account.  It 
is  thought  few  concerns  will  be  found  which  capitalize  this  item, 
for  the  reason  that  they  are  less  justified  in  deferring  the  charge 
on  an  expense  of  this  kind  than  in  almost  any  other  case  imag» 
inable. 

REFERENCES  FOR  COLLATERAL  READING: 

Journal  of  Accountancy,  Vol.  VIII,  page  401. 


114 


CHAPTER   XIX 

CONSIGNMENTS 

The  whole  subject  of  consignment  must  for  the  purpose 
of  discussion  be  divided  into  two  parts,  namely,  consignments 
received  and  consignments  shipped.  A  consignment  may  be 
defined  as  goods  delivered  by  the  party  of  the  first  part  to  the 
party  of  the  second  part  for  the  purpose  of  sale  by  the  party 
of  the  second  part  for  account  of  the  party  of  the  first  part.  The 
party  of  the  first  part  is  known  as  the  consignor.  The  party  of 
the  second  part  is  known  as  the  consignee.  In  dealing  with 
the  subject  it  must  be  looked  at  from  two  points  of  view,  first, 
that  of  the  consignee  and,  second,  that  of  the  consignor. 

In  treating  the  subject  of  consignments  from  the  point  of 
view  of  the  consignee  there  must  be  considered  the  consignment 
invoices,  the  books  to  be  kept,  the  procedure  which  the  account- 
ing follows  and  the  manner  of  showing  the  accounts  both  on  the 
books  of  the  consignee  and  upon  the  balance  sheet.  All  of  these 
will  depend  upon  several  things. 

A  consignment  invoice  will  at  times  take  two  distinct  forms, 
depending  largely  on  whether  or  not  the  sales  prices  of  the  goods 
have  been  agreed  upon  by  the  two  parties.  If  there  has  been 
no  agreement  as  to  the  sales  prices  it  is  probable  that  the  goods 
will  be  invoiced  as  so  many  units  without  any  accompanying 
price  and  consequently  without  any  value.  If  there  is  an  agree- 
ment as  to  the  prices  the  invoice  may  show  the  prices  and  th't 
value  resulting  or  it  may  show  merely  the  quantities  without 
prices  and  value. 

It  may  be  of  interest  before  discussing  the  subject  further 
to  trace  an  invoice  of  consigned  goods  from  the  time  of  their 
receipt  until  such  time  as  they  are  sold  and  accounted  for.  Upon 
receipt  of  the  goods  there  is  the  possibility  that  the  consignee  will 
be  obliged  to  pay  certain  charges  for  freight,  insurance,  cartage 
and  possibly  duty.  Whether  these  charges  are  to  be  borne  by 
the  consignee  or  the  consignor  will  depend  upon  the  contract 
between  the  two  parties  and  would  seem  unimportant  to  the 
discussion  at  this  moment.  The  goods  will  be  put  in  stock  and 
subsequently  sold.     In  connection  with  their  sale  there  may  be 

115 


Principles  of  Accounting 

expenses  such  as  outward  cartage  and  freight,  trade  discount, 
allowances  and  in  some  cases  cash  discount.  At  the  end  of  the 
month  or  at  some  intervening  date  the  consignee  will  render  to  the 
consignor  an  account  for  the  goods  sold,  which  is  technically 
known  as  an  account  sales.  Such  an  account  will  show  the 
gross  sales  less  the  charges  or  expenses  which  are  to  be  borne 
by  the  consignor,  together  with  a  further  deduction  which  has 
been  agreed  upon  for  the  commission  to  the  consignee,  and  as  a 
balance  closing  the  statement  the  amount  which  the  consignor 
is  entitled  to  receive. 

Two  main  questions  are  presented.  The  first  one  is  whether, 
in  the  accounting,  cognizance  shall  be  taken  of  the  consigned 
goods  from  the  time  they  were  received.  The  second  one  is 
whether  any  attention  shall  be  given  to  the  goods  so  far  as 
their  effect  upon  the  general  accounts  is  concerned  until  such 
time  as  they  have  been  sold  and  accounted  for.  In  discussing 
the  first  question  the  invoice  will  have  to  be  taken  into  considera- 
tion. The  procedure  is  somewhat  simplified  if  the  consignment 
invoice  shows  the  price  at  which  the  goods  are  to  be  sold.  It 
becomes  more  difficult  if  no  prices  are  given  in  the  invoice.  In 
such  an  event  prices  must  be  placed  upon  the  goods  in  order  to 
establish  a  basis  for  the  accounting.  These  must  needs  be  arbi- 
trary figures  because  of  the  reason  that  where  prices  are  not 
shown  there  is  the  possibility  that  the  goods  will  not  be  sold  at 
fixed  prices  and  the  price  may  vary  in  accordance  with  the  extent 
to  which  competition  exists  in  the  trading. 

To  illustrate  this  point  a  consignment  of  motor  cycles  may 
be  received  without  any  price  being  shown  on  the  invoice.  The 
understanding  may  be  that  they  are  to  be  sold  for  $250,  with, 
however,  the  qualification  that  they  may  be  sold  for  more  or  less. 
To  take  them  up  at  time  of  receipt  means  that  they  must  be 
priced  at  $250  and  carried  in  the  accounts  at  such  figure.  If 
perchance  they  are  not  sold  at  $250  then  the  original  pricing  must 
be  adjusted  and  the  corresponding  accounts  affected  also  ad- 
justed. If,  however,  the  price  is  fixed  and  the  consignee  has  no 
discretion  in  selling  the  goods  this  difficulty  is  overcome. 
To  summarize  briefly  the  foregoing  and  to  aflFord  a  basis  for 
further  discussion  it  may  be  said  then,  that  goods  received  on 
consignment  may  be  taken  up  at  the  time  of  receipt  or  at  the  time 
of  accounting  regardless  of  whether  prices  are  or  are  not  shown 

116 


Consignments 

on  the  invoice  and  that  if  not  shown  the  goods  must  be  tempo- 
rarily priced  at  a  figure  which  may  or  may  not  require  adjustment 
in  accordance  with  the  agreement  by  the  two  parties. 

The  question  of  books  will  depend  largely  on  whether  the 
goods  are  to  be  taken  up  at  time  of  receipt  or  at  time  of  sale. 
To  illustrate  the  procedure  in  these  two  cases,  let  the  following 
be  considered:  first,  as  to  goods  taken  up  in  the  general  books 
at  the  time  of  their  receipt.  The  invoice  may  be  considered  as 
covering  ten  motor  cycles  priced  at  $250,  with  the  value  of  $2,500 
attached.  The  bookkeeping  operation  will  consist  in  charging 
an  account  called  consignments  or  consignments  received  and 
crediting  an  account  with  the  consignor.  This  process  would  not 
differ  from  the  treatment  of  the  ordinary  purchase  invoice  except 
that  the  credit  account  should  be  designated  in  some  way  to 
show  that  it  is  not  a  liability  account.  The  invoice  would  be 
entered  in  the  purchase  journal  or  voucher  record.  If  controlling 
accounts  are  kept  the  credits  to  consignors  should  be  entered  in 
a  separate  credit  column  or  marked  in  some  way  for  the  purpose 
of  facilitating  their  elimination  at  the  end  of  the  month  from  the 
total  column  in  order  that  such  amounts  will  not  be  included  in 
the  credit  to  the  controlling  account  for  accounts  payable.  Where 
consignments  are  numerous  they  will  usually  be  put  through  the 
purchase  journal  or  voucher  record.  If  they  occur  infrequently 
they  may  be  taken  up  through  the  general  journal  charging 
consignments  and  crediting  the  individual  account  with  the  con- 
signor. 

Next  would  come  any  charges  for  inward  freight,  cartage 
or  insurance.  As  before  stated  these  charges  may  be  stood  by 
the  consignor  or  consignee  depending  upon  the  contract,  but  pre- 
sumably by  the  consignor.  In  the  instance  in  hand  let  it  be  as- 
sumed that  such  charges  amount  to  $20.  The  consignee  upon 
paying  these  charges  or  upon  taking  up  a  liability  for  them  would 
instead  of  charging  his  own  freight  and  cartage  account  charge 
an  account  called  "freight,  cartage,  etc.,  on  consignments." 

Upon  the  sale  of  the  goods  the  consignee  would  issue  a  sales 
invoice  to  his  customer.  The  customer  would  be  charged,  but 
instead  of  the  amount  corresponding  to  the  invoice  being  credited 
to  the  general  sales  account  of  the  consignee  it  would  be  credited 
to  the  asset  account  for  consignments.  In  concerns  where  a  mixed 
business  is  conducted  the  sales  of  consigned  goods  are  segregated 

117 


Principles  of  Amounting 

from  the  sales  of  owned  goods  by  having  a  separate  column  foi 
same  in  the  sales  book. 

It  might  be  assumed  in  this  instance  that  the  motor  cycles 
were  sold  for  $2,500,  the  fixed  price.  The  terms  to  the  customer 
might  provide  for  a  trade  discount  of  10%  and  a  further  dis- 
count of  2%  from  the  net  amount  for  cash  in  10  days.  The 
trade  discount  would  amount  to  $250.  The  cash  discount  will  be 
determined  later.  It  might  also  occur  that  the  customer  would 
make  a  claim  for  allowance  of  $10  for  certain  defects  in  one  of 
the  wheels  and  $15  for  freight  which  he  had  paid  on  account 
of  the  wheels  having  been  shipped  to  him  collect.  Assuming 
these  allowances  to  be  made  the  customer  will  without  question 
have  to  be  credited  in  corresponding  amounts  and  the  accounts 
to  be  charged  when  the  customer  is  credited  will  depend  upon 
the  terms  of  the  contract  as  to  whether  the  charges  are  to  be 
sustained  by  the  consignee  or  consignor.  Since  the  consignee  is 
acting  purely  in  the  capacity  of  an  agent  transacting  business 
for  the  consignor  in  return  for  a  commission  it  is  probable  in 
most  cases  that  the  charges  will  be  sustained  by  the  consignor. 
Thus  the  item  charges  mentioned  would  be  charged  respectively 
to  allowances  on  consignments  and  delivery  charges  on  consign- 
ments. If  the  reverse  conditions  existed  these  items  would  be 
charged  to  the  respective  general  accounts  of  the  consignee  and 
would  affect  his  expense  of  doing  business. 

Looking  at  the  customer's  account  it  would  be  seen  that  it 
was  charged  with  $2,500  and  credited  with  three  items,  namely, 
$250  for  trade  discount,  $10  for  allowances  on  account  of  defec- 
tive goods  and  $15  for  delivery  charges.  The  net  debit  balance 
in  the  account  would  be  $2,225,  which  if  subject  to  a  cash  dis- 
count of  2%,  would  be  further  reduced  in  the  amount  of  $44.50. 

Up  to  this  point  the  account  with  a  consignor  has  not  been 
affected  since  the  original  credit  of  $2,500.  This  amount  repre- 
sents the  gross  figure  which  must  be  accounted  for  to  the  con- 
signor by  the  consignee.  The  goods  having  been  sold  the  agent 
is  now  liable  to  his  principal  for  the  proceeds  of  sale.  In  order 
to  determine  the  extent  of  this  liability  the  consignor's  account 
must  be  adjusted  by  the  various  charges  for  freight,  discount,  al- 
lowances, etc.,  and  the  commission  which  the  agent  is  entitled 
to  for  his  services  in  selling  the  goods.  The  commission  is 
probably  without  exception  figured  on  the  gross  selling  price, 

118 


Consignments 

which  may  have  been  predetermined  or  fixed  by  the  actual  sale. 
If  in  this  case  the  agent  is  to  receive  a  commission  of  5%,  such 
commission  would  amount  to  $125. 

In  attempting  to  determine  the  liability  to  the  consignor's 
several  accounts,  which  are  in  the  nature  of  offsets  to  the  $2,500 
originally  credited  to  the  consignor's  account,  must  be  closed  out 
and  charged  against  it.  These  items  are  inward  freight  on  con- 
signments $20,  trade  discount  $250,  allowances  for  defective 
goods  $10,  delivery  charges  $15,  cash  discount  $44.50.  The 
consignor's  account  would  also  further  be  subject  to  a  charge  of 
$125  for  commission.  It  is  to  be  borne  in  mind  that  when 
this  commission  is  computed  and  charged  against  the  consignor 
a  commission  earned  account  will  be  credited  with  $125.  This 
as  will  be  seen  later  constitutes  the  agent's  earning  or  income 
in  connection  with  the  transactions.  The  customer's  account  will 
presumably  have  been  closed  by  a  credit  of  $2,180.50,  which 
will  have  been  charged  to  the  agent's  cash  account  when  credited 
to  the  customer. 

If  we  may  look  now  at  the  consignor's  account  we  shall  find 
it  credited  with  $2,500  and  charged  with  several  items  aggregat- 
ing $464.50;  a  net  balance  of  $2,035.50.  This  amount  repre- 
sents the  liability  of  the  agent  to  his  principal,  and  its  treatment 
at  this  point  may  be  considered  for  a  moment  from  a  purely 
technical  point  of  view.  Originally  it  existed  as  an  accountability. 
It  has  now  been  transformed  into  a  Hability  and  the  question  to 
be  decided  is  whether  or  not  the  balance  of  $2,035.50  shall  be 
allowed  to  stand  in  the  account  and  the  account  closed  by  a 
charge  in  a  similar  amount  when  the  cash  is  paid  over  to  the 
consignor,  or  whether  the  account  shall  be  closed  by  a  charge  of 
$2,035.50,  transferring  the  balance  to '  a  liability  for  accounts 
payable.  Technically  the  latter  method  is  the  more  correct.  Prac- 
tically the  first  mentioned  method  may  be  more  convenient  and 
no  objection  can  reasonably  be  raised  to  its  use  where  the  transac- 
tions pertaining  to  the  consignment  are  complete.  An  objection 
to  this  method  does  arise,  however,  where  the  transactions  are 
not  complete  or  where  a  partial  accounting  for  goods  sold  becomes 
necessary.  It  will  probably  be  apparent  where  such  conditions 
exist  that  the  balance  in  the  account  represents  a  mixed  situa- 
tion, namely,  one  of  accountability  and  one  of  liability.  Where 
this  occurs  there  will  probably  be  no  question  about  the  desirabil^ 

119 


Principles  of  Accounting 

ity  of  transferring  the  completed  portion  to  a  liability  account 
and  closing  the  latter  subsequently  through  a  debit  at  the  time 
the  cash  is  paid. 

If  we  are  now  to  go  back  for  a  moment  and  look  at  the 
accounts  we  shall  find  a  debit  balance  of  $2,180.50  in  the  cash 
account  representing  the  cash  received  from  customers  and  credit 
balances  in  the  consignor's  account  and  the  commissions  earned 
account,  amounting  respectively  to  $2,035.50  and  $125.  If  now 
settlement  is  had  with  the  consignor  he  will  receive  a  check  for 
$2,035.50,  thus  closing  his  account  and  there  will  be  a  correspond- 
ing credit  to  the  cash  of  $2,035.50  resulting  in  a  debit  balance 
in  the  latter  account  of  $145.  At  this  point  two  accounts  per- 
taining to  these  transactions  will  be  open,  namely,  cash  and 
commissions  earned.  To  analyze  the  balance  in  the  cash  ac- 
count of  $145  it  is  found  to  be  madq  up  of  two  items,  one  of 
$125  representing  the  commission  earned  by  the  agent  and  $20 
representing  the  amount  advanced  by  the  agent  on  account  of 
inward  freight  and  for  which  he  has  been  reimbursed  by  a  de- 
duction in  settlement  with  the  consignor. 

It  sometimes  happens  where  there  are  numerous  accounts 
with  the  consignors  and  partial  settlements  are  made,  that  the 
accounts  with  the  consignors  are  allowed  to  reflect  both  the  ac- 
countability and  the  liability  until  the  books  are  closed,  when 
such  portions  of  the  accounts  as  are  ready  for  settlement  are 
taken  out  of  the  consignors'  accounts  and  transferred  to  corre- 
sponding liability  accounts.  This  facilitates  somewhat  the  prep- 
aration of  the  financial  statements  in  that  it  makes  it  possible  to 
show  on  the  balance  sheet  the  distinction  between  accountabilities^ 
and  liabilities. 

In  the  case  of  consignments  taken  up  at  the  time  of  receipt 
where  the  invoices  are  not  priced,  there  will  be  no  variation  of 
the  above  described  procedure  except  in  so  far  as  the  value  at 
which  the  consignment  is  carried.  No  price  being  shown  on  the 
inventory  there  are  two  possible  variations  which  may  need  to 
be  explained.  In  the  case  just  illustrated  the  goods  were  taken 
up  at  $2,500.  The  two  possible  variations  to  be  examined  are 
first  the  assumption  that  a  value  of  $200  had  been  placed  upon 
each  wheel  and  second  that  a  value  of  $275  had  been  placed 
upon  each  wheel.  In  the  first  instance  the  consignment  account 
would  have  been  charged  with  $2,000  and  the  consignor's  account 

120 


Consignments 

credited  in  a  similar  amount.  Then  if  it  is  to  be  assumed  that  the 
wheels  were  actually  sold  on  a  basis  of  $250  each,  or  $2,500,  there 
will  be  seen  that  two  accounts  must  be  adjusted  in  order  to  keep 
the  books  in  balance  and  make  the  accounts  truthfully  record 
the  transactions.  Since  the  consignment  account  has  been  charged 
with  only  $2,000  and  the  consignor's  account  credited  with  $2,000, 
upon  sale  of  the  wheels  for  $2,500  the  adjusting  entry  neces- 
sarily would  consist  in  charging  the  consignment  account  with 
$500  and  crediting  the  consignor's  account  in  an  equal  amount. 
If,  on  the  other  hand,  a  value  of  $275  each  had  been  placed  upon 
the  wheels  the  consignment  account  would  have  been  charged 
with  $2,750  and  the  consignor's  account  likewise  credited.  If 
again  these  wheels  were  sold  on  a  basis  of  $2,500,  it  would  be 
noted  that  the  consignment  account  as  well  as  the  consignor's 
account  was  originally  charged  and  credited  respectively  with 
$250  too  much  and  an  adjusting  entry  charging  the  consignor 
with  $250  and  crediting  the  consignment  account  with  the  same 
amount  will  consequently  be  necessary. 

The  other  general  proposition  concerning  the  treatment  of 
consignments  involves  their  disposition  when  they  are  not  taken 
up  until  time  of  sale.  Under  these  circumstances  no  entry  is 
made  in  the  general  or  financial  books  at  the  time  of  their  receipt. 
They  are  carried  on  a  memorandum  book  or  stock  record  which 
has  nothing  whatsoever  to  do  with  the  financial  accounts.  They 
are  not  considered  at  all  in  such  accounts  until  they  are  sold. 
The  only  possibility  in  connection  with  them  which  will  require 
an  entry  on  the  general  books  is  when  any  charges  are  paid  or 
advances  or  charges  are  made  against  the  consignor  by  the  agent. 
As  example  of  this  there  may  be  payments  made  by  the  agent 
for  inward  or  outward  freight  and  cartage  or  other  similar  items. 
Notwithstanding  the  fact  that  the  agent  has  made  no  entry  on 
his  books  for  the  consignments,  he  will  of  necessity  charge  the 
consignor's  account  with  any  such  amounts.  At  the  time  of  sale, 
or  subsequently,  an  account  sales  would  be  made  up  showing 
the  net  proceeds  on  the  consignment  exclusive  of  advances  and 
commissions  and  the  amount  of  such  net  proceeds  will  be  credited 
to  the  consignor's  account.  There  will  subsequently  be  made 
a  charge  for  commission  computed  as  before  upon  the  gross  sales 
price  and  this  amount  will  be  charged  to  the  consignor's  account 
simultaneously  with  the  credit  to  the  account  for  commissions 

121 


Principles  of  Accounting 

earned.  The  consignor's  account  will  at  this  point  show  the  net 
balance  which  he  is  entitled  to  receive  and  which  will  be  wiped 
out  by  a  charge  when  the  cash  is  paid. 

Such  is  the  effect  upon  the  books  of  the  two  methods  of 
treating  consignments.  This  whole  subject  is  one  upon  which 
accountants  generally  disagree.  It  is  another  instance  in  which 
no  set  rule  can  be  given.  The  bookkeeping  method  should  be 
determined  largely  by  the  merits  of  individual  cases.  At  times 
it  will  be  more  convenient  and  practicable  to  handle  them  upon 
receipt  in  the  memorandum  form.  At  other  times  circumstances 
will  dictate  that  they  be  taken  up  in  the  books  at  the  time  of 
their  receipt. 

Regardless  of  the  bookkeeping  there  is  still  a  subject  which 
causes  considerable  discussion,  namely,  that  of  the  manner  in 
which  the  subject  shall  be  shown  on  the  balance  sheet.  If  the 
consignments  are  not  taken  up  until  time  of  sale  there  can  of 
course  be  no  possibility  of  any  discussion  arising  for  the  reason 
that  if  they  have  been  sold  the  liability  becomes  evident  and  is 
properly  included  among  the  accounts  payable  in  the  balance 
sheet.  If  perchance  they  have  been  taken  up  at  time  of  receipt 
and  all  have  been  sold  at  the  date  of  the  balance  sheet,  the  same 
thing  will  be  true  since  there  will  be  the  same  liability  as  in  the 
preceding  case.  The  condition  which  causes  the  trouble  is  that 
there  are  goods  remaining  on  hand  at  the  time  of  preparing  the 
balance  sheet.  Some  accountants  insist  that  even  though  carried 
on  the  books  they  shall  not  be  shown  either  on  the  asset  or 
liability  side.  The  supporters  of  this  argument  claim  that  they 
are  neither  assets  nor  liabilities  and  that  the  only  item  in  con- 
nection with  consignments  which  may  ever  appear  upon  the 
balance  sheet  in  connection  with  consignments  received  is  a 
deferred  charge  against  the  consignor  which  may  have  arisen  in 
connection  with  advances  on  account  of  consignments  in  which 
the  account-sales  has  not  yet  been  rendered. 

The  supporters  of  another  argument  hold  that  a  balance 
sheet  is  a  statement  or  financial  condition  taken  from  the  general 
ledger  after  the  books  have  been  closed.  If  the  ledger  shows  a 
debit  for  consignments  and  a  credit  for  consignors  they  maintain 
that  these  items  must  be  shown  on  the  balance  sheet  in  order  to 
have  this  statement  agree  with  the  books.  They  argue  further 
that  such  purpose  is  accomplished  by  showing  the  items  on  the 

122 


Consignments 

balance  sheet  and  there  can  be  no  possible  objection  to  it  80 
long  as  they  are  ear-marked  as  contras  and  not  made  to  repre- 
sent  either  assets  or  habilities. 

It  is  probable  that  in  most  cases  it  will  be  found  more  con- 
venient to  carry  them  on  memorandum  and  not  include  them 
in  the  general  books.  It  is  probably  also  more  correct  from  a 
technical  point  of  view  to  exclude  them  from  the  balance  sheet 
upon  the  theory  that  they  are  neither  assets  nor  liabilities  of 
the  concern  whose  balance  sheet  is  exhibited  and  that  they  are 
carried  on  the  general  books  merely  as  a  matter  of  convenience 
and  the  proper  control  of  the  accounts. 

The  other  instance  in  which  the  question  of  consignments 
arises  is  that  where  goods  are  shipped  on  consignment  instead 
of  being  received.  This  question  can  be  settled  with  facility 
by  dividing  it  for  discussion  into  two  parts,  namely,  cases  wherein 
goods  are  invoiced  at  specific  prices  and  where  they  are  shipped 
only  on  memorandum.  Where  they  are  invoiced  at  a  price  the 
effect  upon  the  accounts  must  be  looked  into.  Here  the  invoices 
will  take  the  form  of  any  other  invoice  for  goods  actually  sold. 
The  goods  will  be  charged  to  the  consignee,  but  they  must  not 
be  credited  to  the  sales  account,  for  the  reason  that  a  sale  has 
not  actually  taken  place  and  it  would  be  anticipating  profits  to 
include  such  invoices  in  the  sales  account.  Upon  being  charged 
to  the  consignee  they  should  be  credited  to  a  consignment  sales 
account.  This  is  frequently  made  possible  by  using  a  separate 
column  in  the  sales  book  for  such  items.  They  are  thus  credited 
to  a  consigned  sales  account  which  is  in  the  nature  of  a  deferred 
credit  to  income.  They  must  not,  however,  be  taken  into  income 
until  such  time  as  they  are  sold. 

In  treating  them  in  this  manner  there  must  be  taken  out  of 
the  cost  of  the  goods  actually  sold,  an  item  representing  the  cost 
of  goods  shipped  on  consignment.  In  a  case  where  the  con- 
signment sales  valu«  is  for  example  $2,500,  and  the  cost  of  such 
goods  $2,000,  the  following  entry  will  serve: 

Consignee : 
To  Consigned  Sales $2,500 

Cost  of  goods  consigned: 

To  Cost  of  goods  sold $2,000 

Upon  the  sale  of  the  goods  and  the  subsequent  report  of  the 
consignee  in  the  form  of  an  account-sales  the  matter  will  have 

123 


Principles  of  Accounting 

to  be  adjusted.  If  we  may  assume  that  the  consignee  is  entitled 
to  deductions  covering  freight  and  other  charges  and  commission 
amounting  to  $300  then  the  entry  will  be  as  follows : 

Consigned  sales $300 

Cash 2,200 

To  Consignee $2,500 

The  account  for  consigned  sales  will  have  been  reduced  by  a 
debit  of  $3CX)  and  may  thereafter  be  released  from  its  deferred 
status  and  closed  out  to  the  sales.  Thus  it  will  be  seen  that 
merged  in  the  sales  for  the  period  there  will  be  an  item  of  $2,200 
and  merged  in  the  cost  of  the  sale  there  will  be  an  item  of  $2,000. 
Thus  merging  in  the  gross  profit  on  sales  for  the  period  an  item 
of  $200. 

It  is  sometimes  found  desirable  instead  of  merging  these 
items  with  general  sales  and  cost  of  sales  of  the  company  to 
close  such  portions  of  the  consigned  sales  account  and  corre- 
sponding cost  of  consigned  goods  sold  into  a  separate  trading 
account  for  consigned  sales  in  order  to  show  the  profit  on  such 
transactions  separately  from  the  general  sales  transactions  of  the 
company.  This  is  done  usually  for  statistical  purposes  in  cases 
where  it  is  desirable  to  ascertain  whether  or  not  it  is  more 
profitable  to  sell  goods  through  agents  than  to  establish  branches 
for  the  conduct  of  such  business. 

If  the  invoices  for  consignments  shipped  are  not  priced  at 
time  of  shipment  and  charged  to  the  agent  the  manner  of  handling 
them  becomes  very  much  simplified.  There  are  two  distinct 
ways  of  doing  this.  One  is  to  ignore  entirely  the  matter  of 
charging  agents  from  the  general  books  and  merely  taking  up 
the  net  proceeds  as  sales  when  the  account  sales  is  received.  This 
of  course  accomplishes  the  desired  result,  but  it  leaves  no  trace 
on  the  books  of  the  goods  themselves.  When  cash  is  received 
sales  are  credited.  The  corresponding  cost  of  these  sales  will 
of  course  be  merged  in  the  cost  of  goods  sold.  The  other 
method  is  to  credit  the  purchase  account  and  charge  a  consignee's 
account  with  the  cost  of  goods,  or  the  estimated  cost,  at  time 
of  shipment  and  upon  receipt  of  the  sales  report,  at  which  time 
sales  are  credited,  to  make  the  necessary  transfer  from  the  con- 
signee's account  to  the  cost  of  goods  sold. 

REFERENCES  FOR  COLLATERAL  READING! 

Accounting,  Practice  and  Procedure,  Dickinson,  pages  133-143. 


CHAPTER   XX 

CAPITAL   LIABILITIEa 

This  term  is  used  to  denote  that  class  of  liabilities  incurred 
in  connection  with  the  acquisition  of  funds  for  capital  purposes. 
Emphasis  is  to  be  placed  upon  the  word  liabilities.  Capital 
invested  by  the  proprietor  as  represented  by  the  proprietor's 
capital  account  or  by  capital  stock  is  not  included  in  this  class. 
Capital  invested  is  to  be  considered  as  an  accountability  rather 
than  a  liability.  Capital  liabilities  usually  take  the  form  of  bonds, 
debentures,  long-term  notes  or  the  so-called  bonds  and  mort* 
gages. 

It  is  a  difficult  matter  to  define  a  bond  in  such  manner  that 
it  will  be  distinctive.  There  are,  however,  some  common  grounds 
on  which  all  can  agree  as  to  the  definition  of  a  bond.  It  is  an 
instrument  containing  a  promise  to  pay  a  definite  sum  of  money 
at  a  time  which  is  fixed  or  determinable,  with  interest  at  a  given 
rate.  When  this  has  been  said  a  bond  has  been  defined.  The 
definition  does  not  differentiate  it,  however,  from  every  other 
class  of  instruments.  An  attempt  to  differentiate  it  results  in 
an  academic  discussion. 

For  practical  purposes  a  bond  seems  to  have  been  sufficiently 
described.  A  discussion,  however,  of  the  theoretical  phase  of 
the  subject  brings  out  some  very  interesting  facts  in  connection 
with  bonds.  There  appears  offhand  to  be  some  distinguishing 
features  to  bonds.  One  of  these  is  that  a  bond  is  secured  by  a 
mortgage  on  certain  property.  If  we  accept  this  as  conclusive 
someone  raises  the  question  as  to  whether  or  not  collateral  notes 
are  secured  by  a  mortgage  on  certain  property.  If  we  attempt 
to  say  that  the  interest  on  bonds  is  payable  at  a  fixed  rate  per 
annum  we  are  confronted  with  the  fact  that  in  the  case  of 
income  bonds  the  interest  is  only  paid  when  earned.  Some  authors 
give  as  the  distinguishing  feature  of  a  bond  the  fact  that  it  is 
issued  as  a  part  of  a  series  of  like  tenor  and  amount  and  in 
most  cases  under  a  common  security.  The  flaw  which  can  be 
picked  in  this  distinction  is  that  collateral  notes  meet  this  require- 
ment. The  point  of  formality  is  sometimes  introduced  to  distin- 
guish a  bond  from  a  note.     It  is  said,  for  example,  that  a  bond 

125 


Principles  of  Accounting 

is  more  formal  than  a  note  and  in  its  common  law  form  resembles 
a  deed  through  seal  and  witnesses.  These  facts  are  all  true  of 
collateral  notes. 

From  the  above  the  difficulties  which  surround  the  task  of 
defining  a  bond  will  be  apparent  and  no  impregnable  definition 
seems  possible.  A  happy  solution  of  the  academic  question  may 
possibly  exist  in  saying  of  a  bond  that  it  is  an  instrument  con- 
taining a  promise  to  pay  a  definite  sum  of  money  at  a  future 
time  which  is  fixed  or  determinable  with  interest  and  when  so 
referred  to  within,  or  upon  the  face  of,  the  instrument.  From  a 
practical  standpoint  it  is  really  of  more  importance  to  be  familiar 
with  the  effect  of  the  bond  upon  the  financial  condition  of  a 
concern  and  the  treatment  of  the  ramification  of  bonds  in  the 
form  of  interest,  than  with  determining  just  what  it  is. 

In  considering  the  relation  of  the  capital  liabilities  to  the 
financial  condition  the  principal  point  of  interest  is  whether  such 
liabilities  are,  or  are  not,  secured.  It  matters  little  whether  the 
obligation  is  called  a  bond,  a  collateral  note  or  a  collateral  trust 
certificate  if  the  obligation  is  secured  by  a  mortgage  upon  certain 
assets  of  the  organization.  It  is  important  to  distinguish  between 
liabilities  which  are  secured  and  those  which  are  unsecured,  the 
latter  being  represented  by  such  instruments  as  debentures  and 
income  bonds. 

A  debenture  is  a  long-term  note.  It  is  similar  to  a  bond  in 
every  respect,  except  as  to  the  matter  of  security.  A  debenture 
is  unsecured.  It  would  seem  incongruous  to  use  the  term  deben- 
ture bond.  Doubtless  no  one  will  dispute  that  a  bond  is  secured 
and  while  the  definition  of  a  bond  was  controverted  because 
of  the  fact  that  other  instruments  were  secured  it  does  not  seem 
proper  to  include  under  bonds  an  instrument  which  is  unsecured. 
A  debenture  may  be  defined  as  an  unsecured  instrument  which 
contains  a  promise  to  pay  a  definite  sum  of  money  at  a  time 
which  is  fixed  or  determinable  with  interest  and  when  so  referred 
to  within,  or  upon  the  face  of,  the  instrument. 

Concerning  income  bonds  it  may  be  said  that  they  are  usually 
unsecured.  They  sometimes  acquire  mortgage  rights  if  the  inter- 
est is  unpaid  and  are  sometimes  secured  in  a  way  by  the  pledging 
of  net  earnings  after  interest  on  prior  claims  has  been  met.  The 
vital  point  regarding  income  bonds  is  that  the  interest  is  not 
paid  unless  earned.    The  determination  of  this  earning  is  largely 

126 


Capital  Liabilities 

in  the  hands  of  the  directors  and  on  account  of  the  contingency- 
connected  with  the  payment  of  interest  they  are  not  a  very- 
desirable  class  of  instrument  to  offer  to  the  pubHc  for  the  purpose 
of  obtaining  funds. 

Bonds,  long-term  notes,  debentures,  income  bonds,  etc.,  have 
to  be  considered  with  regard  to  the  order  in  which  they  rank. 
Bonds  and  secured  notes  will  at  all  times  take  preference  over 
debentures  and  income  bonds.  Bonds  considered  separately  will 
rank  in  accordance  with  the  priority  of  the  mortgage  which  accom- 
panies them. 

One  thing  is  true  of  all  instruments,  regardless  of  whether 
they  are  secured  or  unsecured.  It  is  possible  for  all,  although 
not  probable  in  some  cases,  for  them  to  be  sold  or  disposed  of 
either  at  a  premium  or  at  a  discount.  The  accountant  is  con- 
cerned with  the  disposition  of  such  premium  or  discount  and  as 
usual  two  methods  of  handling  such  items  are  available. 

Taking  up  first  the  case  of  a  bond  or  other  instrument  sold 
at  a  discount,  three  questions  may  be  asked:  first,  "Shall  the 
discount  be  charged  immediately  to  profit  and  loss?";  second, 
"Shall  the  discount  be  charged  annually  direct  to  profit  and 
loss  ?" ;  and  third,  "Shall  it  be  treated  as  addition  to  interest  paid 
annually  on  bonds  and  charged  to  such  interest  account?"  Very 
few  concerns  probably  would  charge  such  an  item  immediately 
to  profit  and  loss.  It  is  thought  that  most  accountants  would 
favor  spreading  the  discount  over  the  life  of  the  bond.  If  this 
point  may  be  considered  as  having  been  settled,  then  the  question 
remains,  "Shall  the  discount  when  it  is  written  off  annually  be 
charged  to  the  interest  account  which  will  subsequently  be  closed 
out  to  profit  and  loss,  or  charged  direct  to  profit  and  loss?"  It 
is  quite  true  that  the  ultimate  result  would  be  the  same  in  both 
cases.  There  is  then  a  further  question,  "What  is  to  be  accom- 
plished by  first  charging  the  amount  written  off  each  year  to  the 
interest  account?"  It  can  be  answered  by  saying  that  in  so  doing 
you  show  the  actual  expenses  in  one  place  of  using  the  money 
acquired  through  the  bonds. 

A  $  1,000  bond  payable  20  years  hence  bearing  interest  at  6% 
and  sold  at  98  would  necessitate  the  setting  up  of  a  discount 
account  with  a  debit  of  $20.  When  the  bond  was  sold  the  entry 
covering  the  transaction  would  show  two  charges,  one  of  $980 
to  cash  and  one  of  $20  to  discount.    These  entries  would  be  offset 

127 


Principles  of  Accounting 

by  a  credit  to  bonds  payable.  The  interest  on  this  bond  for  one 
year  would  be  $60.  Among  the  nominal  accounts  there  would 
appear  one  for  interest  on  bonds  payable.  This  account  prior  to 
closing  would  show  a  debit  balance  of  $60.  The  accounts  would 
ultimately  be  closed  out  to  profit  and  loss.  In  closing  the  accounts 
for  the  year  some  cognizance  must  be  taken  of  the  account  for 
discount,  showing  a  debit  balance  of  $20.  If  this  account  is 
written  off  direct  to  profit  and  loss  annually,  it  will  practically 
ignore  the  fact  that  the  maker  of  the  bond  has  paid  $61  for  the 
use  of  the  money  rather  than  $60.  Discounting  the  bond  is  not 
at  all  different  from  discounting  any  note,  except  that  by  the 
terms  of  most  bonds  the  interest  runs  with  the  bond.  Discount 
has  the  effect  of  increasing  the  interest  paid.  It  is  in  connection 
with  instances  of  this  kind  that  we  hear  of  bonds  being  bought 
at  98  to  yield  6.1%.  The  man  who  buys  a  bond  at  98  receives 
not  only  6%  computed  on  the  face  of  the  bond,  but  in  addition 
$20  which  will  be  paid  to  him  at  maturity. 

After  the  foregoing  discussion  it  would  seem  best  in  charging 
off  discount  to  charge  it  to  the  interest  account  and  thus  make 
such  account  show  the  true  expenses  of  the  borrowed  capital. 
The  accounting  procedure  would  be  somewhat  similar  except 
reversed  as  to  actual  operations  where  bonds  are  sold  above  par  or 
at  a  premium.  In  this  case  the  bonds  might  be  sold  at  102,  mean- 
ing that  in  each  instance  the  maker  of  the  bond  would  receive 
$20  more  than  he  would  have  to  pay  at  maturity.  The  premium 
has  the  effect  of  decreasing  the  yield  on  a  bond  and  therefore  a 
corresponding  effect  upon  the  expenses  of  securing  funds.  For 
this  reason  it  would  seem  desirable  to  follow  the  same  practice 
indicated  in  the  case  of  discount,  namely,  to  credit  the  premium 
on  bonds  sold  to  an  account  so  designated  and  amortize  the 
premium  by  entries,  annually  or  oftener,  extending  over  the  life 
of  the  bond.  Thus  the  amount,  whatever  it  may  be,  will  be 
charged  to  the  premium  account  and  credited  to  the  account  called 
interest  on  bonds  payable. 

There  is  still  to  be  considered  in  connection  with  bonds  the 
manner  of  treating  the  interest.  If  the  books  were  run  on  a 
cash  basis  we  should  expect  to  find  the  interest  on  bonds  and 
similar  instruments  charged  to  the  interest  account  for  such  in- 
struments at  the  time  it  was  paid  and  credited  to  cash.  It  is  not 
probable  that  a  concern  sufficiently  large  to  have  outstanding 

128 


Capital  Liabilities 

bonds  would  make  use  of  the  cash  basis.  In  fact  it  is  perhaps 
this  very  matter  oftener  than  any  other  which  makes  a  concern 
reaHze  the  importance  and  necessity  of  running  their  books  on 
the  accrual  basis.  When  in  connection  with  a  bond  we  see  the 
expression  January  ist  and  July  ist,  it  means  that  such  dates  are 
the  dates  on  which  the  interest  is  due  and  payable.  The  use  of 
such  expression  should  never  convey  the  idea  that  the  interest 
is  not  to  be  booked  until  paid.  Regardless  of  the  date  of  payment 
the  interest  continues  to  accrue  and  even  though  not  payable 
until  January  ist  there  would  be  in  the  case  of  interest  payable 
January  ist  and  July  ist,  six  months'  interest  accrued  at  the  close 
of  the  business  on  December  31st.  The  correct  way  of  treating 
interest  is  to  accrue  it  in  accordance  with  the  time  elapsed,  thereby 
charging  the  expense  account  for  interest  and  crediting  the  lia- 
bility for  the  interest  accrued.  A  distinction  is  sometimes  made 
in  the  balance  sheet  as  between  interest  accrued  and  due  and 
interest  accrued  not  due,  for  the  reason  that  such  a  distinction 
renders  a  balance  sheet  more  comprehensive  and  useful  in 
attempting  to  base  administrative  judgment  thereon.  It  seems 
scarcely  necessary  to  say  in  discussing  the  question  of  accruals 
that  having  charged  interest  and  credited  interest  accrued,  when 
the  interest  is  paid,  charge  is  made  against  the  interest  accrued 
account. 

REFERENCES  FOR  COLLATERAL  READING! 

Accounting,  Practice  and  Procedure,  Dickinson,  pages  39,  87, 
108,  148-150,  258-260. 

Accounting,  Theory  and  Practice,  Lisle,  pages  118,  119. 
Accounts,  Their  Construction  and  Interpretation,  Cole,  pages 
171,  214,  217,  199-202,  333. 

Science  of  Accounts,  Bentley,  pages  53,  54,  62,  104-108,  135- 

136,  144-151.  19^197- 

Auditing,  Theory  and  Practice,  Montgomery,  pages  141,  172, 

195. 

Philosophy  of  Accounts,  Sprague,  Chapter  IX. 
Modern  Accounting,  Hatfield,  Chapter  XIII. 


129 


CHAPTER   XXI 


RESERVES 


A  reserve  is  a  credit  account  which  imposes  a  restriction  of 
one  kind  or  another  either  on  specific  assets  or  the  otherwise  free 
assets  taken  collectively.  The  restriction  may  be  one  of  use  or 
one  of  value.  A  reserve  may  be  created  either  by  charging  an 
asset  account  or  by  charging  proprietorship. 

A  reserve  for  a  building  fund  accumulated  out  of  contribu- 
tions is  established  by  charging  the  fund  and  crediting  the  reserve, 
and  restricts  the  assets  as  to  use.  A  reserve  for  depreciation  of 
property  is  set  up  by  charging  proprietorship  and  crediting  the 
reserve,  and  restricts  the  property  asset  as  to  value.  An  appro- 
priation reserve  arises  through  a  charge  against  proprietorship, 
and  restricts  the  general  assets  as  to  use,  in  that  cash  may  not  be 
taken  for  dividend  purposes  unless  there  is  surplus,  aside  from 
the  appropriation  reserve,  sufficient  to  permit  a  declaration  of 
dividend. 

Much  annoyance  has  been  occasioned  in  the  past,  and  to  some 
extent  continues,  on  account  of  the  tendency  to  confuse  reserves 
as  used  in  an  accounting  sense  with  the  significance  which  the 
word  has  in  banking. 

The  trouble  is  probably  due  in  a  large  measure  to  the  practice 
established  years  ago  by  the  comptroller  of  the  currency  in  accord- 
ance with  the  national  bank  law  of  requiring  national  banks  to 
report  their  reserve  funds.  It  is  probably  true  that  the  word 
"reserves"  was  first  used  to  denote  reserve  funds,  in  the  state- 
ments of  resources  and  liabilities  of  national  banks.  This  was 
perfectly  proper  when  taken  in  connection  with  accounts  of 
national  banks  and  for  the  purpose  which  it  was  intended  to 
serve.  The  origin  of  the  banking  reserve  dates  back  to  the  time 
when  it  was  first  discovered  that  upon  certain  occasions  more 
than  the  ordinary  number  of  depositors  might  apply  at  one  time 
for  the  money  which  they  had  on  deposit.  The  liability  to  de- 
positors was  recorded  by  an  account  called  individual  deposits. 
The  account  was  originally  opened  when  an  individual  deposited 
cash.  When  cash  w'as  received  the  depositor  was  credited.  If 
the  bank  used  its  cash  for  the  purpose  of  making  loans,  the 

130 


Reserves 

general  cash  was  credited  and  "notes  and  discounts"  was  charged. 
If  the  account  of  this  one  depositor  were  magnified  to  represent 
that  of  several  thousand,  it  will  be  seen  that  out  of  the  cash 
received  from  depositors,  there  might  be  set  aside  an  amount 
which  would  be  sufficiently  large  to  meet  any  reasonably  large 
combined  demands  for  withdrawals  on  the  part  of  depositors. 
Such  funds  were  held  in  reserve  and  accordingly  received  the 
name  of  reserve  funds  or  reserves.  This  provision,  it  will  be 
noticed,  was  for  the  purpose  of  providing  for  the  liquidation  of  a 
liability  just  as  a  sinking  fund  would  be  accumulated  for  the  pur- 
pose of  redeeming  outstanding  bonds  at  maturity. 

The  term  sinking  fund  has  become  so  common  that  it  is  prob-  | 
able  no  one  ever  thinks  of  calling  a  sinking  fund  a  reserve.  There 
would  not  appear  to  be  any  reason  why,  when  it  is  well  known 
that  this  confusion  of  terms  exists,  care  should  not  be  taken  in  the 
use  of  terms  and  only  such  terms  used  as  are  descriptive  of  the 
subject  and  at  the  same  time  commonly  accepted  and  understood 
without  question.  This  it  seems  might  be  accomplished  by  calling 
a  fund  "a  fund"  and  a  reserve  "a  reserve."  The  use  of  the  word 
reserve  should  be  avoided  in  connection  with  the  word  fund. 
The  word  fund  should  never  appear  on  the  liability  side. 

The  purposes  which  reserves  serve  are  numerous.  One  is  to 
safeguard  the  business  from  detriment  through  the  withdrawal  of 
capital.  Another  is  that  of  increasing  the  value  of  an  asset  with- 
out increasing  the  capital  or  proprietorship.  Reserves  are  also 
used  as  a  means  of  providing  for  future  losses  in  a  specific  asset 
without  at  the  time  of  loss  affecting  the  capital  or  proprietorship. 
In  a  similar  manner  they  are  used  as  a  means  of  providing  for 
future  losses  of  any  kind  without  at  the  time  of  loss  affecting 
the  proprietorship  or  capital.  Where  a  corporation  takes  over 
another  concern  and  the  net  assets  of  the  concern  taken  over 
exceed  the  par  value  of  the  stock  issued  for  same,  the  excess  is 
sometimes  represented  on  the  books  of  the  corporation  by  a 
reserve.  Such  a  reserve  is  as  a  rule  temporary  in  its  existence  and 
stands  on  the  books  pending  a  revaluation  of  the  assets.  Another 
use  for  reserves  is  that  of  serving  as  a  bookkeeping  expedient 
for  reducing  proprietorship  without  altering  the  asset  account 
affected.  Still  another  use  to  which  reserves  are  frequently  put 
is  that  of  controlling  or  measuring  the  extent  of  an  asset  such 

131 


Principles  of  Accounting 

as  a  fund.  They  are  also  used  to  measure  appropriations  of 
capital  or  surplus. 

A  construction  company  entered  into  a  contract  with  a  certain 
municipality.  A  holding  company  to  which  the  construction 
company  was  subsidiary  guaranteed  satisfactory  performance  on 
the  part  of  the  construction  company.  The  bookkeeper  of  the 
holding  company  was  instructed  to  make  an  entry  which  would 
record  the  transaction.  He  found  some  difficulty  in  making  the 
entry  because  of  the  fact  that  he  could  not  determine  the  amount 
for  which  the  entry  was  to  be  made.  He  saw  that  it  was  neces- 
sary to  record  the  contingent  liabiHty  in  favor  of  the  municipality. 
He  also  decided  that  the  offset  to  the  contingent  liability  was  a 
contingent  asset  in  the  nature  of  a  claim  against  the  construction 
company.  Since  it  was  necessary  to  make  an  entry  and  no  amount 
was  available  he  selected  the  nominal  value  one  dollar  ($i.oo) 
and  made  an  entry  charging  "Guarantee — Columbus  Construction 
Company"  and  crediting  "Reserve  for  Guarantee — Columbus 
Construction  Company."  This  it  will  be  seen  was  purely  a 
memorandum  entry  and  did  not  affect  proprietorship  in  any  way. 
The  entry  was  made  in  order  that  the  facts  should  not  be  lost 
sight  of.  The  use  of  the  word  reserve  in  this  instance  was 
obviously  a  misuse. 

Two  partners  were  engaged  in  a  manufacturing  business. 
They  agreed  between  them  that  50%  of  all  profit  should  be 
reserved  and  not  available  for  drawings.  The  capital  was  small, 
unequally  invested  and  drew  interest.  The  reserves  did  not 
draw  interest.  It  was  the  purpose  in  establishing  the  reserves 
to  build  up  the  business  and  strengthen  it ;  to  protect  it  from  the 
inroads  of  excessive  drawings.  The  account  on  the  books  was 
called  "Partners'  Reserves."  In  this  case  there  was  somewhat 
more  justification  for  the  use  of  the  word  than  in  the  other 
instance  cited.  The  reserve  was  a  part  of  proprietorship.  It 
seems,  however,  to  have  been  placed  in  an  account  other  than 
those  of  the  partners  simply  because  of  the  fact  that  it  was  non- 
interest  bearing. 

An  industrial  corporation  placed  a  mortgage  on  its  property 
and  sold  bonds.  The  bonds  contained  a  clause  which  stated  that 
a  reserve  should  be  created  annually  out  of  profits.  The  reserve 
was  created  and  at  maturity  equalled  the  amount  of  the  bond 
issue.     The  company  had  from  time  to  time  been  investing  its 

132 


Reserves 

surplus  funds  in  securities.  At  maturity  these  were  sold  and  the 
outstanding  bonds  redeemed.  The  account  was  called  "Reserve 
for  Redemption  of  Bonds."  The  account  represented  a  true 
reserve,  but  it  was  not  appropriately  named.  Redemption  of  an 
outstanding  obligation  cannot  be  effected  through  an  account  on 
the  same  side  of  the  books.  The  bonds  were  redeemed  out  of 
the  proceeds  of  the  securities  sold.  The  account  should  have 
been  called  "Reserve  for  Protection  of  Bonds."  This  is  not 
suggested  as  an  improvement  of  the  accounting  nomenclature 
now  existing;  rather  as  describing  the  conditions  in  this  case. 
The  reserve  in  reality  served  as  a  protection  to  the  bond  issue 
in  that  it  prevented  the  surplus  funds  of  the  company  from  being 
withdrawn  as  dividends. 

Another  corporation  was  desirous  of  revaluing  certain  land 
which  it  owned  in  accordance  with  values  in  the  surrounding 
neighborhood.  Some  of  the  directors  favored  increasing  the 
value  of  the  land  and  crediting  the  amount  of  the  increase  to 
surplus.  Others  opposed  this  proceeding  on  the  ground  that 
land  values  fluctuate  and  the  value  might  decrease.  They  con- 
tended that  if  the  credit  were  made  to  surplus  the  amount  would 
be  available  for  dividends;  the  dividends  might  be  paid  and 
the  value  subsequently  decline.  It  was  finally  decided  to  revalue 
the  land  and  credit  the  increase  to  a  "Reserve  for  Appreciation 
of  Land." 

Many  concerns  make  provision  for  losses  on  accounts  by 
charging  profit  and  loss  and  crediting  a  reserve  for  such  purposes. 
Consequently  we  frequently  see  the  account,  "Reserve  for  Bad 
Debts."  It  is  not  an  uncommon  occurrence  to  find  a  reserve  for 
contingent  losses.  The  two  reserves  are  similar.  One  is  for  a 
specific  purpose.     The  other  is  for  a  general  purpose. 

A  firm  of  contractors  and  builders  decided,  on  account  of 
labor  troubles,  etc.,  to  incorporate.  The  combined  capital  invest- 
ment of  the  partners  was  approximately  $100,000.  In  order  to 
escape  the  state  tax  on  corporations,  it  was  decided  to  incorporate 
for  $25,000  and  have  the  partners  take  notes  of  the  corporation 
for  the  balance  of  their  old  capital.  As  taken  over  by  the  cor- 
poration, the  plant  and  equipment  was  appraised  and  was  found, 
together  with  the  other  assets,  to  exceed  the  liabilities  and  capital 
stock  by  about  $25,000.  This  amount  was  credited  to  an  account 
called  "Reserve  for  Capital  Surplus."    While  the  amount  prob- 

133 


Principles  of  Accounting 

ably  would  have  been  available,  as  surplus,  for  dividends,  it  was 
the  desire  of  the  partners  to  have  it  reserved  as  surplus.  This 
had  the  effect  of  withholding  the  amount  from  both  the  capital 
stock  account  and  the  partners'  note  accounts  as  well  as  prevent 
its  use  for  distribution  as  dividends. 

A  reserve  for  depreciation  is  merely  an  expedient  for  esti- 
mating the  decrease  in  the  value  of  an  asset  without  affecting  the 
asset  account.  It  is  the  reverse  of  writing  down  the  asset  on 
account  of  depreciation.  The  former  method  is  to  be  preferred 
since  it  permits  the  account  to  show  the  facts  with  regard  to  the 
asset  without  the  introduction  of  any  indefinite  factor  such  as 
depreciation.  If  the  depreciation  is  excluded  the  account  will 
show  the  original  cost  of  the  asset,  with  subsequent  additions 
and  deductions  at  cost.  Such  a  reserve  effects  a  reduction  in. 
capital,  in  an  amount  which  corresponds  to  the  estimated  depre- 
ciation of  the  asset,  for  the  purpose  of  showing  the  estimated 
value  of  the  asset. 

A  coal  company  obtained  a  part  of  its  land,  in  which  mines 
were  located,  through  borrowed  capital.  The  capital  was  obtained 
through  the  sale  of  bonds  secured  by  a  mortgage  on  the  property. 
The  mortgage  provided  that  a  reserve  equal  to  ten  cents  (loc.) 
a  ton  should  be  created  annually  out  of  earnings  and  that  an 
amount  equal  to  the  reserve  should  be  deposited  with  a  sinking 
fund  trustee  for  the  redemption  of  the  bonds. 

A  certain  hospital  decided  to  devote  the  income  from  certain 
sources  to  the  erection  of  a  building  for  housing  its  nurses.  It 
will  be  noted  that,  given  the  commonly  accepted  meaning,  the 
income  would  not  accomplish  such  purpose.  The  receipts  corre- 
sponding to  the  income  would,  however,  provide  the  necessary 
fund.  The  income  may  have  taken  the  form  of  subscriptions. 
The  payment  of  the  subscriptions  may  have  followed.  The  reserve 
in  this  case,  as  in  that  of  the  coal  company,  had  the  effect  of 
measuring  the  fund  and  restricting  its  use  for  special  purposes. 

The  government,  federal,  state,  and  municipal,  is  in  the  habit 
of  apportioning  its  revenues  for  various  purposes  by  appropria- 
tion. The  appropriation  bill  usually  reads  "and  there  is  hereby 
appropriated  out  of  any  moneys  not  otherwise  appropriated  the 
sum  of  *  *  *."  This  has  the  effect  of  restricting  the  general 
surplus  and  confining  the  application  of  the  appropriation  to  a 
specific  purpose.    The  respective  appropriation  reserves  have  the 

134 


Reserves 

effect  of  measuring  the  various   funds,  or  of  determining  the 
equity  of  each  appropriation  in  the  funds  appropriated. 

In  a  similar  manner,  a  mercantile  concern  may  appropriate  a 
part  of  its  surplus  for  a  specific  purpose.  Some  concerns  have 
created  reserves  for  pensions  and  sick  benefits  among  employees 
out  of  their  surplus.  Where  the  concern  is  sufficiently  well 
established  and  has  sufficient  cash  available  at  any  time  to  meet 
payments  to  employees,  it  is  not  considered  necessary  to  fund  the 
reserve.  The  funds  are  allowed  to  remain  in  the  business;  the 
company  pays  interest  for  their  use ;  the  amount  due  to  the  fund 
is  determined  by  the  reserve  to  which  the  interest  is  credited. 

A  well-known  biscuit  concern  distributed  its  product  to  dealers 
in  elaborate  tins.  The  dealers  were  obliged  to  deposit  with  the 
company  seventy-five  cents  (75c.)  for  each  tin.  Receipts  of 
this  kind  were  charged  to  cash  and  credited  to  a  reserve.  The 
money  was  used  in  the  business  in  the  same  manner  as  a  bank 
uses  its  deposits.  In  the  panic  of  1907,  the  streets  for  blocks 
around  the  plant  of  this  company  were  filled  with  trucks  return- 
ing empty  tins.  The  reserve  had  not  been  funded.  No  cash  had 
been  set  aside  for  this  purpose.  This  was  a  contributing  factor 
in  the  failure  of  the  company  which  followed  in  a  short  time. 

Reserves  are  created  in  two  ways.  One  is  by  charging  profit 
and  loss  or  surplus  and  crediting  the  reserve.  The  other  is  by 
charging  an  asset  and  crediting  the  reserve.  As  examples  of  the 
first  we  have :  partners'  reserves,  reserves  for  losses,  reserves  for 
depreciation,  reserves  for  sinking  funds,  and  appropriation  I 
reserves.  As  illustrating  the  second  method  there  are:  reserves 
for  appreciation,  reserves  for  capital  surplus,  reserves  for  con- 
tributions. It  is  claimed  by  some  that  reserves  may  only  be 
created  out  of  surplus.  This  may  be  conceded  if  all  additions  to 
assets  are  considered  as  accretions  of  capital  and  are  first  credited 
to  capital  in  spite  of  the  fact  that  they  are  subsequently  to  be 
set  up  as  reserves. 

The  use  of  reserves  can  scarcely  be  considered  without  look- 
ing at  each  with  regard  to  the  purpose  for  which  it  was  created. 
A  reserve  for  safeguarding  the  business  against  withdrawal  of 
capital  will  presumably  stand  the  same  as  a  capital  account,  until 
such  time  as  the  business  has  become  sufficiently  strong  to  per- 
mit the  desired  withdrawal  of  capital.  A  reserve  for  losses 
will  be  credited  with  future  additions  and  charged  with  any 

135 


Principles  of  Accounting 

losses,  A  reserve  for  depreciation  will  increase  through  credits 
until  it  equals  the  book  value  of  the  asset  which  it  offsets.  This 
statement  must  of  course  be  qualified  with  the  remark  that 
consideration  will  be  made  for  the  residual  value  of  the  asset 
if  there  is  any.  Broadly  speaking,  a  reserve  for  a  sinking  fund 
will  increase  until  it  equals  the  obligation  which  the  sinking  fund 
is  to  liquidate.  Appropriation  reserves  are  as  a  rule  more  stable' 
on  the  credit  side.  They  may  in  mercantile  concerns  fluctuate 
on  both  sides.  As  used  by  governmental  bodies  there  is  usually 
one  credit.  This  of  course  assumes  that  there  are  no  deficiency 
appropriations.  The  frequency  with  which  the  debits  occur  will 
depend  upon  whether  the  appropriation  is  for  capital  or  revenue 
purposes.  If  for  the  latter,  charges  will  be  made  against  the 
appropriation  reserve,  as  disbursements,  or  charges  which  will 
subsequently  result  in  disbursements,  are  made.  If  the  appro- 
priation is  for  capital  purposes  the  reserve  will  probably  be 
closed  by  one  debit  closing  the  appropriation  reserve  into  capital 
surplus.  Where  appropriation  reserves  are  used  by  mercantile 
concerns  both  the  debits  and  credits  may  fluctuate  by  additional 
appropriations  and  interest  credits  on  the  one  hand  and  charges 
for  payments  on  the  other.  Cases  are  known  where  mercantile 
concerns  have  made  appropriations  for  capital  purposes.  The 
effect  of  such  procedure  is  only  to  tie  up  the  surplus  and  acts 
as  a  commitment  to  improvement  or  extension  before  dividends 
are  declared. 

Reserves  for  appreciation  may  likewise  fluctuate.  They  are 
set  up  with  a  credit.  If  the  asset  declines  in  value  they  are 
subject  to  charge.  Reserves  for  capital  surplus  are  subject  to 
the  same  remarks.  Reserves  for  contributions  are  credited  when 
the  contribution  is  received.  If  received  for  current  purposes 
the  reserve  is  charged  as  frequently  as  disbursements  are  made. 
If  for  capital  purposes,  the  reserve  is  charged  only  at  such  time 
as  the  capital  asset  has  been  acquired  and  becomes  a  part  of  the 
general  fund.  As  long  as  the  contribution  exists  as  a  special 
fund  so  long  will  there  be  no  charge  against  the  reserve  for  the 
purpose  of  transferring  it  to  the  capital  surplus. 

The  disposition  of  reserves  is,  broadly  speaking,  the  same  in 
each  case.  They  serve  the  purpose  for  which  they  were  set  up. 
Created  out  of  surplus  they  revert  to  surplus  if  they  have  not 
been  obliterated  by  use.     A  reserve  for  losses  will  be  charged 

136 


Reserves 

with  the  losses.  If  the  estimate  for  the  losses  has  been  too  great, 
the  balance  in  the  reserve  may  be  closed  out  to  surplus.  If, 
however,  the  reserve  were  too  small  an  additional  credit  would  be 
necessary,  if  the  practice  of  providing  a  reserve  for  losses  were 
to  be  consistently  followed.  The  same  thing  might  be  said  of 
reserves  for  depreciation  so  far  as  the  adequacy  of  the  reserve  is 
concerned.  The  disposition,  when  the  reserve  account  equals 
the  asset  account,  is  largely  a  matter  of  choice.  The  reserve  may 
be  debited  and  the  asset  credited,  or  the  asset  may  be  credited  and 
the  reserve  debited.  One  consists,  technically,  in  closing  out 
the  reserve  against  the  asset;  the  other  closing  out  the  asset 
against  the  reserve.  A  sinking  fund  reserve  will  be  closed  out 
to  surplus  after  the  sinking  fund  has  been  used  to  liquidate  the 
liability  shown  by  the  bond  account.  Appropriation  reserves  will 
be  reduced  by  charges  when  set  up  for  revenue  purposes.  Any 
unrequired  balance  will  revert  to  surplus  as  will  any  reserve  for 
capital  appropriations. 

Reserves  for  appreciation  will  usually  stand  until  the  increased 
value  has  been  determined  beyond  a  doubt.  When  such  has 
taken  place  the  reserve  may  be  closed  into  surplus.  Reserves 
for  capital  surplus  are  very  similar.  As  long  as  they  represent 
tentative  values  they  should  stand.  When  the  value  of  the  assets 
which  they  represent  is  unquestionable  they  may  apparently  be 
closed  into  surplus.  The  question  concerning  this  matter  is, 
whether  or  not  the  surplus  so  acquired,  and  without  doubt  avail- 
able for  dividends,  has  been  earned.  The  ConsoHdated  Laws  of 
1909  (chapter  59,  section  28,  volume  5,  folio  4004)  provide  that 
"It  shall  be  unlawful  for  the  directors  or  managers  of  any  incor- 
porated company  in  this  state  (New  York)  to  make  dividends 
excepting  from  the  surplus  profits  arising  from  the  business  of 
such  corporation." 

The  law  does  not  state  whether  the  "dividends"  shall  be  paid 
in  cash  or  in  stock ;  neither  does  it  define  "surplus  profits."  These 
two  points,  however,  are  practically  settled  by  the  case  of  Wil- 
liams vs.  Western  Union  Telegraph  Company  (93  N.  Y.,  162). 

The  Western  Union  Telegraph  Company  declared  a  stock 
dividend  out  of  surplus  and  a  stockholder  brought  suit  to  prevent 
the  payment  of  the  dividend.  The  court  held  that  the  action  of 
the  company  was  not  in  violation  of  the  law.  After  defining 
surplus  as  being  the  excess  of  assets  over  liabilities  and  capital, 

137 


Principles  of  Accounting 

the  decision  continues :  "Such  surplus  belongs  to  the  corporation 
and  is  a  portion  of  its  property,  and,  in  a  general  sense,  may  be 
regarded  as  a  portion  of  its  capital,  but  in  a  strictly  legal  sense 
it  is  not  a  portion  of  its  capital,  and  is  always  regarded  as  surplus 
profits." 

It  would  thus  appear  that  a  reserve  for  capital  surplus  need 
only  stand  until  such  time  as  the  value  of  the  offsetting  asset  has 
been  definitely  determined  when  the  reserve  may  be  closed  into 
the  surplus  proper. 

A  reserve  for  contributions  will  depend  so  far  as  its  disposi- 
tion is  concerned  upon  the  purpose  to  which  the  fund  is  devoted. 
If  the  fund  is  used  for  revenue  purposes,  the  reserve  will  be 
closed  by  charges  from  time  to  time  as  disbursements  are  made. 
If  it  is  used  for  capital  purposes  the  reserve  will  be  closed  out 
to  surplus  or  general  reserve,  as  it  is  sometimes  called  in  institu- 
tions, when  the  disbursements  have  been  made  for  such  purposes. 

Reserves  often  are  the  subject  of  discussion  on  account  of 
their  location  on  the  balance  sheet.  Generally  speaking,  there  are 
two  ways  of  showing  them :  one  is  as  deductions  from  assets,  the 
other  is  on  the  liabilities  side,  either  as  a  separate  group  or  as  a 
part  of  capital.  An  explanation  of  the  reason  for  placing  them 
on  the  right  hand  side  of  the  balance  sheet  will  probably  explain 
also  why,  in  accordance  with  such  theory,  they  should  not  be 
deducted  from  assets  on  the  left-hand  side.  Reserves  are  con- 
sidered as  restricted  capital.  Capital  is  the  excess  of  assets  over 
liabilities.  Capital  is  the  equity  in  the  assets  taken  collectively, 
providing,  of  course,  that  there  are  liabilities.  To  admit  that  one 
particular  asset  belongs  to  the  proprietor  while  some  other  par- 
ticular asset  belongs  to  the  creditors  would  be  unusual.  Since 
reserves  are  a  part  of  capital  and  capital  is  an  equity,  it  is  con- 
sidered unwarranted  to  deduct  a  portion  of  capital  from  a  specific 
asset. 

A  careful  study  of  the  subject  seems  to  indicate  that  some 
differentiation  should  be  made  as  to  reserves  in  deciding  whether 
they  should  be  shown  on  the  liabilities  side  or  deducted  from 
assets.  Where  they  reduce  values  of  specific  assets,  even  though 
the  reduction  is  but  an  estimate,  as  in  depreciation  or  in  doubtful 
accounts,  it  seems  preferable,  for  practical  purposes,  that  they 
should  be  deducted  on  the  asset  side  from  the  items  to  which 
they  relate.    Where  they  restrict  the  use  of  certain  assets,  measure 

138 


Reserves 

equities  not  specifically  ear-marked,  or  show  a  restriction  of 
general  assets  through  proprietorship  set  aside  for  the  purpose, 
it  appears  better  to  show  them  on  the  liabilities  side.  Reserves 
for  special  purpose  funds,  reserves  for  insurance,  not  funded, 
and  appropriation  reserves,  are  examples  in  the  latter  class. 

It  has  sometimes  been  stated  that  one  purpose  in  avoiding  the 
deduction  of  reserves  from  assets  was  to  prevent  an  admission 
of  depreciation  of  property  in  the  case  of  a  fire.  Theoretically 
it  was  maintained  that  if  the  reserves  were  deducted  from  the 
assets  it  was  an  admission  of  the  depreciation,  whereas  the 
reverse  was  true  if  the  reserves  were  set  up  broad. 

The  standard  fire  insurance  policy  usually  contains  the  fol- 
lowing clause :  "The  insured,  ^s  often  as  required,  shall  exhibit 
to  any  person  designated  by  this  company  all  that  remains  of  any 
property  herein  described  and  submit  to  examinations  under  oath 
by  any  person  named  by  this  company  and  subscribe  the  same  ; 
and,  as  often  as  required,  shall  produce  for  examination  all  books 
of  account,  bills,  invoices,  and  other  vouchers,  or  certified  copies 
thereof,  etc."  It  would  thus  appear  that  a  mere  formality  so  far 
as  the  balance  sheet  is  concerned  would  not  serve  as  a  protec- 
tion against  a  searching  investigation  on  the  part  of  the  insur- 
ance company  which  it  is  assumed  would  determine  the  value  of 
the  property  destroyed. 

REFERENCES  FOR  COLLATERAL  READING  I 

Journal  of  Accountancy,  Vol.  XI,  pages  261,  421. 


139 


CHAPTER   XXII 

THE   RELATION   OF   FUNDS   TO   RESERVES 

The  word  fund  as  used  herein  is  intended  to  be  representative 
of  a  special  fund ;  one  which  has  been  set  aside  out  of  the  general 
assets  to  be  devoted  to  some  specific  use.  The  reserve  in  question 
must  have  been  created  out  of  proprietorship.  The  discussion 
revolves  very  largely  around  the  question  of  whether,  in  practice, 
one  is  essential  to  the  other. 

If  in  institutional  or  municipal  organizations  certain  receipts, 
for  example,  donations  for  laboratory  equipment  in  a  school  of 
chemistry,  or  the  receipts  of  certain  fines  in  the  municipal  courts, 
were  to  be  set  aside  and  devoted  solely  to  the  purposes  specified, 
there  would  be  no  question  about  the  necessity  for  crediting  a 
reserve,  every  time  the  fund  was  debited.'  This  would  be  neces- 
sary in  order  that  the  fund  might  be  controlled  and  its  use 
restricted. 

If  in  an  industrial  corporation  the  employees  should  contribute 
jointly  with  the  management  to  a  fund  for  pensioning  aged  and 
injured  employees,  which  fund  was  to  be  carried  as  an  account  on 
the  books  of  the  corporation  there  would  be  no  question  about  the 
propriety  of  making  similar  entries.  The  corporation  becomes 
practically  a  trustee  for  the  fund  and  is  not  entitled  to  show  the 
fund  as  an  asset  which  in  part  represents  proprietorship.  The 
corporation  is  accountable  to  its  employees  for  the  fund  and  there- 
fore must  set  up  a  reserve  to  protect  it. 

On  the  other  hand,  suppose  that  the  mortgage  securing  an 
issue  of  corporate  bonds  states  that  "there  shall  be  set  aside 
annually,  out  of  profits,  the  sum  of  fifty  thousand  dollars  ($50,- 
000)  to  retire  said  bonds  at  maturity,"  then  two  questions  arise. 
The  first  one  is,  what  does  the  clause  say;  the  second,  is  what 
does  It  mean. 

Profits  are  understood  to  mean  the  excess  of  income  over 
expense.  They  are  shown  by  nominal  accounts  which  measure 
through  a  summary  called  the  profit  and  loss  account  the  extent 
to  which  the  assets  collectively  have  increased.  That  portion 
of  the  assets  which  corresponds  to  profit  cannot  be  identified  as 
such,  as  a  rule,  although  the  profit  is  indisputably  vested  in  the 

140 


The  Relation  of  Funds  to  Reserves 

assets,  Thus  it  may  be  reasoned  that  disbursements  cannot  be 
made  out  of  profits;  they  may  be  made  out  of  cash  in  amounts 
equal  to  certain  measurements  of  profit.  Obviously  the  clause 
previously  mentioned  must  have  been  drawn  by  someone  unfa- 
miliar with  technical  accounting  expressions. 

To  determine  the  meaning  of  the  clause  is  perhaps  more  diffi- 
cult than  to  decide  just  what  it  says.  Is  it  the  intention  to 
provide  for  a  sinking  fund,  or  a  reserve,  or  both?  It  appears  as 
if  the  only  satisfactory  manner  of  settling  this  question  would 
be  to  ask  the  man  who  prepared  the  mortgage  containing  said 
clause. 

For  the  purpose  of  discussion  the  question  may  be  asked, 
"What  would  be  the  effect  of  either  or  both  of  these  provisions 
upon  the  parties  in  interest?"  Such  parties  are  the  bondholders 
and  the  corporation. 

The  object  of  a  sinking  fund  is  to  provide  the  cash  necessary 
to  redeem  at  maturity  certain  bonds  outstanding.  The  bond- 
holder is  interested,  not  in  whether  he  is  paid  out  of  profits  or 
otherwise,  but  in  receiving  cash  for  the  bonds  which  he  holds. 
He  is  willing  to  accept  nothing  else,  as  a  rule. 

The  mere  creation  of  a  reserve  in  this  case  does  not  produce 
the  cash  necessary  to  pay  the  bondholder.  It  Hmits  or  restricts 
the  free  equity  of  proprietorship  in  the  assets.  Regardless  of 
the  object,  the  effect  is  that  of  reducing  the  profits  available  for 
distribution  as  dividends  or  addition  to  proprietorship. 

During  the  accumulation  of  the  fund  the  profits  are  made 
to  suffer  annually  to  the  extent  of  the  deposit.  The  reserve 
increases  as  the  fund  accumulates.  Finally,  as  the  fund  equals 
the  indebtedness  and  the  bonds  are  redeemed,  the  reserve  is 
released  and  reverts  to  surplus  or  proprietorship.  Apparently 
the  stockholders  are  deprived  of  these  profits  until  the  bonds 
have  been  paid  off. 

One  of  the  most  striking  illustrations  of  the  application  of 
the  sinking  fund  principle  is  that  of  a  mine.  The  land  is  pur- 
chased for  the  mineral  which  it  contains.  The  location  of  the 
land,  or  character  of  its  surface,  many  times  prevents  its  use  for 
anything  after  the  mineral  has  been  extracted.  The  buildings, 
machinery  and  shaft  equipment  are  practically  worthless  after 
the  mine  is  exhausted.  The  stock  in  trade  is  the  mineral.  If 
capital  is  invested  in  the  mineral  and  the  mineral  is  sold  care 

141 


Principles  of  Accounting 

must  be  taken  that  the  proceeds  are  not  erroneously  considered 
as  representing  profits  entirely.  No  merchant  will  consider  that, 
having  sold  an  article  for  fifteen  dollars  which  cost  ten,  he 
has  made  fifteen  dollars.  No  mining  concern  should  consider 
the  mineral  which  is  extracted  as  being  pure  profit.  There  is 
usually  an  element  of  cost  and  if  the  cost  is  not  reckoned  with, 
depleted  capital  will  result.  If  the  capital  is  contributed,  the 
stockholders  may  be  surprised  to  learn  that  the  apparently  ex- 
cessive dividends  have  been  made  up  in  part  of  capital  which 
was  being  returned  to  them.  If  the  capital  is  borrowed  and,  for 
example,  secured  by  a  mortgage  on  the  property,  the  bondholders 
may  find  that  while  during  the  life  of  the  bond  they  have  been 
receiving  the  interest  regularly,  at  maturity  the  company  defaults 
on  the  principal,  and  the  property,  on  which  the  naortgage  was  a 
specific  lien,  has  dwindled  into  so  much  earth  without  any  value. 

The  variation  in  effect  of  the  above  mentioned  methods  of 
procedure  may  be  seen  in  three  propositions  based  on  practically 
the  same  hypothetical  case.  The  case  is  as  follows: 
I  The  Lawtimer  Coal  Company  with  a  paid-in  capital  of 
$25,000  represented  by  capital  stock,  purchased  a  tract  of  coal 
land  for  $100,000.  The  land  was  paid  for  with  $25,000  in  cash 
and  an  issue  of  6%  twenty-year  bonds,  secured  by  a  mortgage  on 
the  land,  amounting  to  $75,000.  The  land  was  estimated  to  yield 
and  did  yield  50,000  tons  of  coal. 

The  first  proposition  assumes  that: 

a.  The  mortgage  made  no  provision  for  a  sinking  fund. 

b.  Fifty  thousand    (50,000)    tons   of  coal  were  sold  at 

five  dollars  ($5.00)  a  ton. 

c.  The  expenses  of  operation  for  the  period  of  twenty 

years  amounted  to  $35,000. 

d.  The  profit  after  deducting  $90,000  for  interest  on  the 

bonds  was  distributed  as  dividends. 

e.  At  the  maturity  of  the  bonds  there  was  a  balance  of 

$100,000  in  accounts  receivable. 

Skeleton   ledger   accounts    showing   the    transactions   would 
appear  as  follows : 

Cost  of  Land  Bonds  Outstanding 


$100,000     $100,000  I  $75,000 

142 


The  Relation  of  Funds  to  Reserves 


Capital  Stock 


Accounts  Receivable 


$25,000 


Cost  of  Sales 


$250,000 

$250,000 
$100,000 

Sales 


$150,000 
100,000 


$250,000 


$100,000     $100,000 


$250,000     $250,000 


Cash 

Operating  Expenses 

$150,000 

$35»ooo 
90,000 
25,000 

$35,000 

$3  5. 000 

$150,000 

$150,000 

Interest  on  Bonds 


Dividends 


$90,000       $90,000 


$25,000       $25,000 


Profit  and  Loss 


Cost  of  sales $100,000 

Operating  expenses. .  35, 000 

Interest  on  bonds. . .  90,000 

Dividends 25,000 


Sales $250,000 


$250,000 

Balance  Sheet 


$250,000 


Assets 
Accounts  receivable .  $100, 000 


Total  assets $100,000 


Liabilities  and  Capital 

Capital  stock $25,000 

Bonds  outstanding. ,       75,000 

Total  liabilities  and 
capital $100,000 


143 


Principles  of  Accounting 

The  yield  of  the  mine  was  5o,cxx)  tons.  The  cost  per  ton  was 
accordingly  $2.00  per  ton.  The  cost  of  sales  was  made  up  of 
50,000  tons  at  $2.00  per  ton,  or  $100,000.  The  depletion,  as  the 
charge  was  made  to  cost  of  sales,  gradually  reduced  the  cost  of 
land  until  at  maturity  it  was  entirely  wiped  out.  The  position  of 
the  company  at  the  end  of  the  period  is  no  worse  than  at  the  be- 
ginning. The  cost  of  land  at  $100,000  at  the  beginning  has  been 
replaced  by  accounts  receivable  in  the  same  amount.  The  position 
of  the  bondholders  is  not  so  favorable.  At  the  beginning  the 
bonds  were  secured  by  a  mortgage  on  the  land  which  contained, 
as  subsequently  developed,  coal  which  sold  for  $250,000.  At 
the  end  the  bonds  are  still  secured  as  to  payment  of  principal  by 
a  mortgage  on  the  land,  but  the  valuable  contents  of  the  land 
have  been  removed.  The  specific  property  upon  which  the  mort- 
gage operated  as  a  lien  has  been  stripped  of  its  value.  The 
desire  of  the  company  to  redeem  the  bonds  may  be  above  ques- 
tion. The  ability  to  do  so  is  hampered  by  lack  of  cash.  The 
bondholders  are  at  the  mercy  of  the  company. 

The  second  proposition  assumes  that: 

a.  The  mortgage  provides  for  a  sinking  fund  of  $1.50 

a  ton. 

b.  Fifty  thousand  (50,000)  tons  of  coal  were  sold  at  five 

dollars  ($5.00)   a  ton. 

c.  The  expenses  of  operation  for  the  period  of  twenty 

years  amounted  to  $35,000. 

d.  The   profit   after  deducting  $90,000   for   interest   on 

bonds  was  distributed  as  dividends. 

e.  At  the  maturity  of  the  bonds  there  was  a  balance  of 

$100,000  in  accounts  receivable. 
/.     The  company  had  borrowed  on  notes  payable  and  was 
still  owing  at  the  maturity  of  the  bonds,  $75,000. 

The  skeleton  ledger  accounts  setting  forth  the  transactions 
under  this  proposition  follow: 

Cost  of  Land  Bonds  Outstanding 

$100,000     $100,000  $75,000 

144 


The  Relation  of  Funds  to  Reserves 
Capital  Stock  Accounts  Receivable 


$25,000 


$250,000 


$250,000 
$100,000 


$150,000 
100,000 

$250,000 


Cost  of  Sales 


Sales 


$100,000     $100,000 


$250,000     $250,000 


General  Cash 

Sinking  Fund  Cash 

$150,000 
75,000 

$75,000 
35.000 
90,000 
25,000 

$7S.ooo 

$225,000 

$225,000 

Notes  Payable 

Operating 

Expenses 

$75,000 

$35,000 

$35,000 

Interest  on  Bonds 

Dividends 

$90,000 

$90,000 

$35,000 

$25,000 

Profit  and 

Loss 

Cost  of  sales $100,000 

Operating  expenses. .  35, 000 

Interest  on  bonds. . .  90,000 

Dividends 25,000 


Sales $250,000 


$250,000 

Balance  Sheet 


$250,000 


Assets 

Accounts  receivable .  $  1 00, 000 
Sinking  Fund  cash . .       75,000 


Total  assets $175,000 


Liabilities  and  Capital 

Capital  stock $25,000 

B  onds  outstanding . .       75, 000 

Notes  payable 75,000 

Total  liabilities  and- 

capital $175,000 


145 


Principles  of  Accounting 

The  situation  as  represented  by  the  above  balance  sheet  is,  it 
will  be  noted,  decidedly  more  favorable  to  the  bondholders.  The 
land  has  disappeared,  the  same  as  in  the  first  case,  but  so  much 
of  it  as  represented  borrowed  capital  has  been  replaced  by  a 
sinking  fund.  This  fund  the  company  is  bound  by  the  provision 
of  the  mortgage  to  devote  to  the  retirement  of  the  bonds. 

The  company  is  as  well  off  as  in  the  preceding  instance.  The 
bonds  are  due,  but  the  cash  is  available  with  which  to  redeem 
them.  There  are  notes  outstanding  to  the  extent  of  $75,000,  but 
they  should  be  amply  provided  for  as  the  accounts  receivable  are 
realized. 

One  fact  must  be  brought  to  the  attention  in  this  proposition. 
That  is  the  fact  that  the  payment  of  dividends  was  made  possible 
through  the  borrowing  power  of  the  company.  Dividends  might 
have  been  declared  quite  easily  since  there  was  sufficient  profit 
to  warrant  them.  To  obtain  the  cash  necessary  to  pay  the  divi- 
dends is  another  matter.  The  presumption  should  exist,  it  seems, 
that  if  the  profits  are  bona  fide  and  accordingly  are  vested  in 
sound  assets,  sooner  or  later  the  same  assets  will  be  realized  and 
the  payment  of  dividends  would  seem  to  depend  entirely  upon 
the  ability  of  the  organization  to  borrow  the  necessary  cash  if 
perchance  such  borrowing  should  become  necessary.  There  does 
not  seem  to  be  any  reason  why  the  establishment  of  the  sinking 
fund,  which  in  this  case  is  merely  a  setting  aside  of  a  part  of  the 
cost,  should  interfere  with  the  payment  of  dividends,  which  is  a 
distribution  of  funds  representing  the  profit. 

The  third  proposition  assumes  that: 

a.  A  reserve  for  replacement  equal  to  $1.50  a  ton  is  to 

be  created  out  of  profits  before  any  dividends  are 
declared. 

b.  Fifty  thousand  (50,000)  tons  of  coal  were  sold  at  five 

dollars  ($5.00)  a  ton. 

c.  The  expenses  of  operation  for  the  period  of  twenty 

years  amounted  to  $35,000. 

d.  The  interest  on  the  bonds  was  $90,000. 

e.  At  the  maturity  of  the  bonds  there  was  a  balance  of 

$100,000  in  accounts  receivable. 

In  this  case  the  skeleton  ledger  accounts  show  the  transactions 
as  follows: 

146 


The  Relation  of  Funds  to  Reserves 
Cost  of  Land  Bonds  Outstanding 


|ioo,ooo 


$100,000 


Capital  Stock 


$7S,ooo 


Accounts  Receivable 


$25,000 


Cost  of  Sales 


$250,000 


$250,000 


$150,000 
100,000 


$250,000 


Sales 


$100,000     $100,000 


General  Cash 


$250,000     $250,000 


Reserve  for  Replacement. 


$150,000 


$150,000 
$  25,000 


$35,000 
90,000 
25,000 

$150,000 


$25,000 


Interest  on  Bonds 


$35,000       $35,000 


$90,000       $90j000 


Profit  and  Loss 


Cost  of  sales $100,000 

Operating  expenses. .  35, 000 
Interest  on  bonds. . .  90,000 
Prcidsion  for  reserves      2  5 ,  000 


Sales $250,000 


$250,000 

Balance  Sheet 


$250,000 


Assets 

Cash $  25,000 

Accounts  receivable.     100,000 


Total  assets . ,  $125,000 


Liabilities  and  Capital 

Capital  stock $25,000 

Bonds  outstanding. .       75,000 

Reserve  for  replace- 
ment        25,000 

Total  UabiHties  and 

capital $125,000 


147 


Principles  of  Accounting 

Here  as  in  the  first  proposition  the  bondholders  are  in  an 
undesirable  position.  The  reserve  for  replacement  has  been 
created,  not,  however,  to  the  extent  intended.  The  reserve  should 
have  amounted  to  $75,000.  It  amounts  to  only  $25,000.  The 
reason  is  that  the  profits  were  not  sufficiently  large  to  permit  of 
its  creation  in  the  amount  originally  planned.  It  so  happens 
in  this  case  that  the  cash  equals  the  reserve. 

It  is  a  coincidence  in  this  case  since  there  is  no  connection  or 
relation  in  practice  between  the  two  accounts.  Profits,  it  should 
be  remembered,  are  vested  in  all  the  assets.  The  reserve  for 
replacement  has  in  this  case  taken  the  place  of  profits  and  repre- 
sents therefore  merely  the  extent  to  which  the  profits  in  the 
assets  exist. 

The  company  lacks  funds  with  which  to  meet  its  outstanding 
bonds.  The  reserve  does  not  provide  these  funds.  It  has  no 
connection  with  the  funds.  All  that  it  has  accomplished  is  to 
prevent  the  declaration  of  dividends  because  it  reduced  the  profits 
so  that  there  were  none  left  out  of  which  they  might  be  declared. 
Obviously  if  dividends  are  not  declared  there  can  be  no  divi- 
dends paid. 

A  fourth  proposition  might  combine  both  sinking  fund  and 
reserve  provisions.  In  such  a  case  the  balance  sheet  would  be 
the  same  as  in  the  third  proposition  except  that  the  sinking  fund 
cash  in  the  amount  of  $75,000  would  replace  the  general  cash  of 
$25,000  and  there  would  be  a  liability  of  $50,000  for  notes  pay- 
able. This  would  prevent  the  declaration  of  dividends  until 
such  time  as  the  bonds  were  redeemed  and  the  reserve  released. 

REFERENCES  FOR  COLLATERAL  READING : 

Modern  Accounting,  Hatfield,  Chapters  VIII-XI-XII. 


148 


CHAPTER   XXIII 

PROPRIETORSHIP 

Proprietorship  is  usually  understood  to  mean  ownership.  In 
connection  with  business  organization  it  signifies  ownership  of 
the  assets.  If  there  were  no  liabilities  outstanding  this  would 
be  strictly  true.  Such  a  condition  rarely  exists.  There  are  few 
concerns  which  have  no  liabilities.  The  existence  of  liabilities 
has  the  effect  of  merging  with  the  proprietor's  interest  in  the 
assets  that  of  the  creditors.  It  may,  therefore,  be  said  that  pro- 
prietorship is  that  ownership  of  the  assets  of  a  business  organi- 
zation which  is  measured  by  the  assets,  or,  where  liabilities  exist, 
by  the  excess  of  assets  over  liabilities.  Proprietorship  is  also 
called  capital. 

Proprietorship  may  be  represented  by  various  accounts,  de- 
pending upon  the  legal  type  of  organization.  Within  the  different 
classes  of  organization  the  proprietary  account  may  be  subdivided 
for  convenience  in  classification.  In  sole  proprietorship,  copart- 
nership, or  joint  venture,  the  capital  is  represented  by  the  proprie- 
tors' accounts.  Thus  there  may  be  found  accounts  such  as  "John 
Marshall,  Proprietor,"  or  "John  Marshall,  Capital."  This  account 
may  show  not  only  the  original  investment  of  "John  Marshall," 
but  any  subsequent  credits  for  profits,  salary,  interest  or  capital. 
For  convenience,  separate  accounts  are  often  set  up  for  profits, 
salary  or  interest,  so  that  the  capital  account  shows  the  invest- 
ment of  capital  with  subsequent  additions  to  or  deductions  from 
same.  Accounts  for  salary,  interest  or  profits  should  be  consid- 
ered as  adjuncts  of  the  proprietor's  account.  They  may,  quite 
properly,  appear  on  the  books,  but  should  not  appear  in  the 
balance  sheet  as  such.  They  constitute  a  part  of  the  proprietor- 
ship as  much  as  that  represented  by  the  proprietor's  account. 
If,  technically  speaking,  the  rule  of  bookkeeping  relative  to  the 
closing  of  books  were  complied  with,  they  would  be  closed  out 
to  the  proprietor's  account  before  the  final  trial  balance  were 
taken.  In  joint  associations  and  corporations,  the  proprietary 
accounts  are  those  of  capital  stock,  divided  as  occasion  requires 
to  represent  various  classes  of  stock,  and  with  adjuncts  for 
undivided  profits  or  iov  surplus.    Unlike  sole  proprietorship  and 

149 


Principles  of  Accounting 

copartnership,  separate  accounts  are  maintained  with  the  adjuncts 
as  well  as  with  the  capital  stock.  This  is,  in  a  measure,  due  to 
the  fact  that  a  corporation  has  its  capital  stock  fixed  by  law. 
Without  the  consent  of  the  proper  representative  of  the  State 
the  capital  stock  may  neither  be  increased  nor  decreased.  The 
capital  stock  is  presumed  to  represent  the  investment  of  capital. 
By  reason  of  the  fact  that  it  is  fixed,  any  excess  of  assets  over 
liabilities  and  capital  stock  is  called  surplus  or  undivided  profits. 

There  is  little  distinction  made  between  the  two  words.  If 
a  shade  of  difference  in  meaning  is  observed,  undivided  profits 
may  be  taken  as  profits  which  will  be  distributed  within  a  rea- 
sonably short  time  as  dividends,  whereas  surplus  consists  of 
undivided  profits  which  have  passed  through  the  stage  of  avail- 
ability for  distribution  and  have  been  allowed  to  remain  vested 
in  the  assets  to  strengthen  the  corporation.  Surplus  is  rather 
an  accumulation  of  profit.  There  can  be  no  doubt  that  undivided 
profit  and  surplus  attach  to  the  capital,  thereby  constituting 
proprietorship.  They  are,  however,  kept  separately  in  the  books, 
for  purposes  of  convenience,  and  shown  separately  in  the  balance 
sheet  for  purposes  of  information. 

Capital  stock  is  evidence  of  share  ownership  in  the  net  assets 
of  a  corporation.  By  net  assets  is  meant  the  excess  of  assets 
over  liabilities.  The  documentary  evidence  is  a  mere  piece  of 
paper  on  which  certain  officers  of  the  corporation  have  certified 
to  the  fact  that  the  party  named  in  the  certificate  is  the  owner 
of  a  certain  number  of  shares.  The  certificates  are  printed 
because  they  may  be  issued  in  large  numbers,  and  much  unneces- 
sary writing  is  thus  avoided.  The  ownership  is  expressed  in 
shares  because  of  simplicity.  In  a  corporation,  for  example, 
with  one  thousand  shares  outstanding,  the  owner  of  five  hundred 
shares  is  one-half  owner.  There  is  no  apparent  reason  why  such 
fact  could  not  be  stated  in  the  certificate.  It  would  be  perfectly 
easy  to  do  so  if  the  fractions  were  always  small,  but  they  are 
not.  One  might  imagine  the  complication  which  would  arise, 
for  instance,  in  the  U.  S.  Steel  Corporation,  where  there  are 
ten  million  shares.  If  the  share  ownership  were  expressed  in 
fractions,  the  certificate  of  a  party  holding  362  shares  would 
read  362-io,ooo,oooths  of  the  capital  stock. 

The  par  of  capital  stock  varies  in  different  companies.  One 
hundred  dollars  is  probably  the  most  common  amount.     Stocks, 

150 


Proprietorship 

the  par  value  of  which  is  fifty  dollars  and  twenty-five  dollars, 
respectively,  are  also  frequently  seen.  Pennsylvania  Railroad 
stock  is  an  example  of  fifty-dollar  par  stock.  Stock  is  not  usually 
issued  until  fully  paid  for,  although  certificates  are  sometimes 
seen  in  circulation  when  only  part  paid.  The  certificates,  in 
such  cases,  usually  bear  an  endorsement  on  their  face  stating 
the  amount  paid. 

A  stock  issue  is  sometimes  preceded  by  what  is  known  as 
"scrip."  As  used  here,  scrip  is  a  receipt  issued  for  payments  on 
account  of  stock  subscriptions  which  it  is  intended  will  be  re- 
deemed in  stock.  In  such  cases,  scrip  occasionally  circulates  in 
lieu  of  stock.  Scrip  is  also  issued  at  times  for  fractional  shares 
of  stock. 

There  are  one  or  two  points  in  connection  with  stocks  which 
accountants  should  keep  in  mind  when  engaged  in  counting 
securities,  namely :  to  be  on  the  alert  for  stocks  which  are  not 
fully  paid  and  for  stocks  the  par  of  which  is  less  than  one  hundred 
dollars.  Failure  to  observe  these  precautions  is  liable  to  result 
in  failure  to  balance  the  par  of  the  stocks  under  review. 

The  consideration  for  the  issue  of  capital  stock  varies  in 
different  States.  In  some  of  the  most  prominent  States  the  con- 
sideration is  as  follows : 

Arizona — money  or  money's  worth  (general  principles  of 
law). 

Delaware — cash,  labor  done,  personal  property,  real  prop- 
erty or  leases. 

Maine — cash,  services  rendered,  property. 

Massachusetts — cash,  property,  tangible  or  intangible, 
services  or  expenses. 

New  Jersey — money,  property. 

New  York — money,  labor  done,  property  actually  received 
for  the  use  and  lawful  purposes  of  such  corporation. 

Pennsylvania — money,  labor  done,  property  actually  re- 
ceived. 

South  Dakota — money,  labor  done,  property  actually  re- 
ceived. 

West  Virginia — property,  services  or  other  things  of  value. 

Capital  stock  is  usually  classified  as  preferred  and  common. 
The  former  may  be  preferred  as  to  dividends,  or  as  to  assets 

151 


Principles  of  Accounting 

at  time  of  liquidation,  or  both.  As  to  dividends,  it  is  sometimes 
Icnown  as  cumulative  preferred.  Voting  power  may  attach  to 
either  preferred  or  common  stock  or  to  both. 

Where  stock  is  preferred  as  to  dividends  it  is  understood,  or 
in  fact  agreed,  that  a  certain  rate  per  cent,  of  dividend  will  be 
paid  on  the  preferred  before  any  dividends  are  paid  on  the  com- 
mon. If  the  preference  is  as  to  assets,  it  is  understood  to  mean 
that  in  liquidation  the  preferred  stockholders  will  be  paid  off 
in  full  out  of  the  available  assets  before  anything  is  paid  to  the 
holders  of  the  common  stock. 

In  the  case  of  cumulative  preferred  stock  the  rate  per  cent, 
stipulated  in  the  certificate  accrues  in  favor  of  the  stockholders, 
whether  earned  and  paid  or  not.  Accumulations  in  favor  of  pre- 
ferred stockholders  in  such  cases  must  be  paid  in  full  before 
any  dividends  can  be  paid  to  common  stockholders.  For  example, 
where  the  stock  in  question  is  seven  per  cent,  cumulative  pre- 
ferred, and  the  dividend  is  unearned  for  a  period  of  three  years, 
dividends  to  the  extent  of  twenty-one  per  cent,  must  be  paid 
to  the  holders  of  such  stock  before  any  dividends  on  the  common 
stock  may  be  declared. 

Where  such  a  condition  exists,  the  propriety  of  showing  a 
liability  for  same  in  the  balance  sheet  frequently  presents  itself. 
Without  giving  the  matter  careful  consideration  it  might  appear 
proper  that  such  a  liability  should  be  shown.  This  position  may 
be  taken  on  the  ground  that  the  dividend  is  in  the  nature  of 
interest,  and  accrues  by  virtue  of  what  might  be  considered  an 
agreement  on  the  part  of  the  company  to  pay  such  dividends. 
This,  however,  is  not  true.  What  the  company  does  agree  to 
do  is  to  pay  a  dividend  equal  to  seven  per  cent.,  if  earned.  In 
the  absence  of  action  on  the  part  of  the  directors  in  declaring 
a  dividend  no  liability  arises.  It  would,  therefore,  seem  improper 
to  consider  the  cumulative  dividend  as  accruing,  since  there 
may  never  be  sufficient  surplus  earnings  to  justify  any  dividend. 
It  is  usually  conceded  that  no  liability  for  such  dividends  should 
appear  on  the  balance  sheet,  but  a  sense  of  honesty  and  fairness 
would  seem  to  indicate  that  a  foot-note  stating  the  exact  situation 
should  be  appended  to  the  balance  sheet. 

In  connection  with  proprietorship  an  important  question  arises 
in  cases  where  capital  stock  is  donated.  As  previously  stated, 
proprietorship  is  measured  by  the  net  assets.     Any  increase  in 

152 


Proprietorship 

the  assets  without  a  corresponding  increase  in  the  liabilities 
carries  with  it  an  increase  in  the  proprietorship.  Capital  stock, 
if  donated,  is  an  asset.  If  the  rule  above  stated  were  true,  the 
proprietorship  would  be  increased.  The  extent  of  the  increase 
would  depend  upon  the  value  assigned  to  the  donated  stock.  To 
fix  this  value  is  the  difficulty  which  is  presented.  In  the  majority 
of  cases  it  is  probable  that  the  stock  donated  was  issued  originally 
for  patents,  trademarks,  good-will,  or  similar  assets,  and  was 
donated  in  order  that  it  might  be  sold  to  raise  cash  for  current 
needs.  Obviously,  it  is  worth  what  it  sells  for,  or  perhaps,  rather, 
its  value  may  be  fixed  at  what  it  sells  for.  To  the  extent  of 
this  value  it  increases  the  proprietorship;  that  is,  if  the  assets 
for  which  it  was  originally  issued  were  correctly  valued. 

Two  views  concerning  the  treatment  of  donated  stock  obtain. 
The  first  view  holds  that  the  assets  for  which  the  stock  was 
originally  issued  were  worth  the  value  assigned  to  them,  and 
consequently  the  proceeds  of  the  donated  stock,  when  sold, 
increase  proprietorship.  The  second  view  holds  that  the  value 
of  the  assets  is  fictitious,  and  admittedly  arbitrary,  and  that  the 
proceeds  of  the  donated  stock  should  be  used  to  reduce  such 
valuation.  For  the  purpose  of  illustrating  the  two  views,  let  a 
case  be  assumed  in  which  capital  stock  to  the  extent  of  $100,000 
is  issued  for  patents;  $40,000  of  stock  (par  value)  is  subse- 
quently donated,  to  be  sold  for  the  purpose  of  raising  such  cash, 
and  is  sold  for  $25,000. 

Under  the  procedure  followed  in  accordance  with  the  view 
first  expressed,  patents  would  be  charged  and  capital  stock  out- 
standing credited  in  the  amount  of  $100,000.  Upon  receipt  of 
the  donated  stock,  treasury  stock  would  be  charged,  and  an 
account,  variously  termed  "donation  account,"  "working  capital" 
and  "capital  surplus  suspense,"  is  credited,  in  the  amount  of 
$40,000.  At  the  time  of  sale  cash  would  be  charged  with  $25,000 
and  treasury  stock  credited  in  an  equal  amount.  The  treasury 
stock  account  will  now  show  a  debit  balance  of  $15,000,  whereas 
no  stock  remains.  The  donation  account  will  show  a  credit 
balance  of  $40,000.  At  this  point  the  treasury  stock  account  is 
closed  out  to  the  donation  account,  leaving  a  credit  balance  in 
the  latter  of  $25,000.  This  balance  may  be  allowed  to  remain 
in  the  account,  as  representing  capital  surplus,  and  impliedly, 
perhaps,  not  available  for  dividends,  or  it  may  be  closed  out  to 

153 


Principles  of  Accounting 

the  general  (profit  and  loss)  surplus  account.  There  would 
appear  to  be  no  legal  objection  to  making  this  increase  in  the 
surplus  available  for  cash  dividends.  To  do  so,  however,  would 
be  to  defeat  the  object  of  the  donation ;  and  since  the  controlling 
interest  in  the  stock  is  usually  held  by  the  donor,  such  procedure 
would  probably  never  take  place  in  practice.  A  stock  dividend 
for  the  purpose  of  distributing  such  surplus  would  appear  more 
logical,  and  would  seem  to  be  free  from  objection. 

In  accordance  with  the  second  view  above  mentioned,  the 
entries  would  be  the  same  up  to  the  point  of  closing  the  donation 
account.  The  credit  balance  in  the  donation  account,  namely, 
$25,000,  is  closed  out  against  the  account  for  patents,  standing 
at  $100,000,  thereby  reducing  same  to  $75,000.  The  accounting 
which  accords  with  this  view  is  held  by  many  to  be  conservative 
practice.    It  is  surely  that,  and  perhaps  ultra-conservative. 

Those  who  hold  this  view  contend  that  the  donation  of  the 
stock  is  evidence  of  the  fact  that  the  assets  were  not  worth  the 
par  value  of  the  stock  which  was  issued  for  them.  Opposers 
of  this  view  hold  that  "judgment  of  the  directors,  in  the  absence 
of  fraud  in  the  transaction,  is  conclusive  as  to  the  value  of  the 
property  purchased."  Whether  or  not  the  value  can  be  disproven, 
the  practice  which  follows  the  view-point  illustrated  in  the  first 
case  above  mentioned  has  undoubtedly  enabled  mining  and  real 
estate  development  companies  to  take  advantage  of  unsuspecting 
investors. 

In  recent  years  many  states  have  enacted  laws  making  pro- 
vision for  capital  stock  without  par  value.  In  some  states  both 
preferred  and  common  stock  is  included.  Where  preferred  stock 
without  par  value  is  issued,  a  redemption  value  must  be  placed 
on  each  share.  While  this  procedure  may  appear  to  create  a 
ridiculous  situation,  it  has  the  effect  of  making  possible  the  issue 
of  the  stock  at  such  price  as  the  directors  may  fix.  A  share  of 
common  stock  without  par  value  denotes  the  ownership  of  an 
aliquot  part  in  the  excess  of  assets  over  liabilities.  Stock  with- 
out par  value  while  apparently  simplifying  matters  creates  a  num- 
ber of  situations  in  which  there  are  knotty  problems.  Laws  of 
the  particular  state  in  which  the  corporation  is  organized  should 
always  be  consulted,  particularly  as  to  stated  capital,  surplus, 
and  dividends. 


154 


CHAPTER  XXIV 

THE   INCOME-FROM-SALES    GROUP 

This  group  comprises  gross  sales,  on  the  one  hand,  against 
which  will  oppose  such  items  as  return  sales,  trade  discount, 
allowances,  rebates,  outward  freight,  and  outward  cartage.  The 
result  of  opposing  these  last  named  items  against  the  first  is 
income  from  sales,  or  primary  income.  It  is  to  be  understood 
that,  notwithstanding  the  fact  that  a  concern  selling  goods  has 
been  selected  as  an  illustration,  the  theory  of  accounting  involved 
would  apply  in  cases  of  concerns  selling  services,  transportation, 
or  what  not. 

A  sale  is  a  contract  between  two  parties,  wherein  certain 
specified  goods  ready  for  delivery  have  been  offered  and  ac- 
cepted. A  sale  must,  therefore,  comply  with  the  legal  require- 
ments of  a  contract.  It  is  not  necessary  for  payment  to  be  made 
in  order  that  a  sale  may  take  place.  It  is,  of  course,  vitally 
important  to  the  vendor  that  he  receive  pay  for  his  goods,  but 
for  the  purpose  of  this  discussion  the  payment  may  be  treated 
as  a  secondary  matter.  If  there  has  been  a  meeting  of  the  minds 
with  regard  to  certain  specified  goods,  and  such  goods  are  ready 
for  delivery,  the  sale  has  taken  place.  The  price  attached  to  the 
goods  fixes  for  the  vendor  the  gross  income  from  the  sale.  It 
will  thus  be  seen  that  there  is  established  an  item  called  gross 
sales. 

In  certain  instances,  goods  having  been  once  sold  are,  for 
one  reason  or  another,  returned,  and  accepted  by  the  vendor. 
This  gives  occasion  for  the  account — returned  sales  or  sales 
returns.  Such  items  should  be  considered  not  as  reducing  the 
gross  income  from  sales,  but  in  effect  a  cancellation  of  the  sales 
which  were  originally  made.  It  would,  accordingly,  seem  proper 
to  deduct  sales  returns  from  gross  sales  and  show  the  result  as 
the  net  sales.  Whether  or  not  an  account  is  raised  on  the  ledger 
is  immaterial;  a  caption  for  same  should  appear,  however,  in 
any  comprehensive  statement  of  income.  If  it  were  desired  to 
have  an  account  for  net  sales  on  the  ledger,  the  account  would 
be  raised  only  at  the  time  of  the  closing  of  the  books,  and  would 
serve  as  a  sub-group  account. 

155 


Principles  of  Accounting 

The  selling  price  of  goods  is  composed  of  selling  cost  plus 
profit.  Selling  cost  is  made  up  not  only  of  cost  of  goods  before 
the  expense  of  selling  the  goods,  but  the  expense  of  adminis- 
tration and  the  expense  of  securing  or  protecting  capital,  and 
allowances  or  deductions  which  it  will  be  necessary  to  make  from 
the  selling  price  of  goods.  The  last  named  items  -  include  those 
previously  mentioned,  such  as  trade  discounts,  allowances,  etc. 
These  items  appear  to  bear  a  close  relation  to  the  selling  price, 
and,  having  been  considered  in  fixing  the  selling  price,  and  it 
paving  been  conceded  in  advance  that  the  selling  price  will  be 
reduced  to  the  extent  of  these  deductions,  it  would  appear  logical 
to  treat  them  as  deductions  from  sales.  It  is  immaterial  whether 
or  not  such  an  account  be  maintained  in  the  ledger,  but  if  such 
were  the  case  it  would  be  set  up  only  at  the  time  of  closing 
the  books,  and  the  items  embraced  in  this  sub-group  closed  into 
the  account. 

Trade  discount  is  an  expedient  for  adjusting  a  list  price. 
To  one  customer  the  goods  might  be  quoted  at  $2.00  a  dozen,  less 
10  and  5 ;  to  another  customer  the  price  might  be  $2.00  a  dozen, 
less  10  and  5  and  2.  The  same  goods  might  be  sold  one  year  at 
$2.00  less  10;  another  year  at  $2.00  less  73^.  Instead  of  raising 
the  list  price  the  discount  might  be  lowered.  The  question  might 
be  asked,  "Why  not  change  the  list  price  instead  of  going  to  the 
extent  of  the  trouble  involved  in  changing  a  number  of  dis- 
counts?" The  objection  to  this  would  probably  be  seen  when  it 
is  realized  that  some  concerns  publish  extensive  and  expensively 
illustrated  catalogs  and  price  lists.  By  changing  the  discounts  it 
is  not  necessary  to  alter  the  catalogs  or  price  lists.  It  will  thus  be 
seen  that  trade  discount  is  a  useful  expedient  for  adjusting  prices. 
The  point  especially  to  be  kept  in  mind  in  this  connection,  how- 
ever, is  that  the  vendor  concedes  in  advance,  and  takes  into  con- 
sideration in  fixing  his  selling  price,  the  fact  that  he  will  receive 
so  much  less  for  his  goods.  It  has  been  argued  by  some  authors 
that  an  account  for  trade  discount  has  no  place  in  the  general 
ledger.  The  statement  has  even  been  made  that  such  account  is 
never  found  in  the  general  ledger.  It  is  modestly  suggested  by 
the  author  that  if  financial  statements  are  to  be  comprehensive  an 
account  for  trade  discount  might  with  propriety  exist.  It  is 
conceded  that  most  concerns  deduct  trade  discount  from  the  face 
of  sales  invoices  and  enter  such  invoices  in  their  books  net.    To 

156 


The  Income-from-Sales  Group 

enter  them  broad  would  undoubtedly  involve  some  additional  work 
on  the  part  of  the  bookkeepers.  In  a  large  concern,  however, 
where  a  highly  developed  departmental  organization  exists,  and 
the  fixing  of  prices  is  delegated  to  the  head  of  the  sales  depart- 
ment or  the  sales  manager,  an  account  for  trade  discount  would 
undoubtedly  serve  as  an  index  of  the  efficiency  of  the  sales  man- 
ager to  a  certain  extent.  It  is  questionable,  of  course,  whether 
the  expense  involved  in  the  additional  work  of  recording  the  in- 
voice broad  would  offset  the  benefits  accruing  to  the  administrative 
officers  from  the  information  furnished  by  the  keeping  of  ati 
account  for  trade  discount.  The  practice  to  be  followed  should 
be  guided  entirely  by  a  decision  of  this  kind  in  each  particular 
case.    It  is  not  possible  to  state  a  general  rule  concerning  it. 

Allowances  may  cover  defective  goods,  or  goods  broken, 
damaged  or  lost  in  transit.  Allowances  have  the  effect  of  reduc- 
ing the  amount  which  will  be  received  from  the  sale  of  goods, 
and  will  usually  be  deducted  by  the  vendee  in  settlement.  They 
are  usually  represented  by  credit  memoranda,  and  on  account  of 
their  close  relation  to  sales,  and  the  fact  that  they  affect  the 
amount  which  will  be  received  from  sales,  they  are  treated  as 
deductions  from  sales. 

Rebates  are  of  much  the  same  nature  as  allowances.  It  may 
appear  somewhat  inconsistent  to  even  mention  the  subject  of 
rebates,  since  the  practice  of  rebating  is  prohibited  by  law.  The 
author  respectfully  refrains  from  offering  any  suggestions  as 
to  what  should  be  done  if  rebates  are  actually  found.  It  will 
suffice,  perhaps,  in  connection  with  this  topic,  to  state  that  rebates 
are,  in  effect,  special  allowances,  and,  if  they  exist,  bear  the  same 
relation  to  sales  that  allowances  bear. 

Some  explanation  will,  perhaps,  be  necessary  as  to  the  reason 
for  treating  outward  freight  as  a  deduction  from  sales.  It  is 
probable  that  the  most  common  practice  is  to  treat  it  as  a  selling 
expense.  It  seems,  however,  not  to  be  properly  included  in  such 
group  if  a  sale  is  conceded  to  have  taken  place  when  the  goods 
ready  for  delivery  had  been  offered  and  accepted.  The  expense 
appears  rather  to  be  one  of  delivering  the  goods  than  selling 
them.  It  is  argued  by  some  that  the  matter  of  delivery  is  an 
important  factor  in  determining  the  sale ;  that  in  certain  instances 
it  serves  as  an  inducement  to  the  purchaser;  that  many  times,  if 
the  goods  were  not  delivered  by  the  vendor,  they  would  not  be 

157 


Principles  of  Accounting 

sold.  While  this  may  be  true,  the  fact  still  remains  that  If  the 
vendor  bears  the  expense  of  delivering  the  goods  he  receives 
that  much  less  for  his  goods,  and  he  has  taken  that  fact  into 
consideration  in  fixing  his  selling  price. 

Outward  cartage  is  in  the  same  class  with  outward  freight. 
The  account  may  contain  merely  items  of  expense  in  connection 
with  services  rendered  by  some  drayman,  or  it  may  contain  a 
proportion  of  the  stable  expenses,  etc.,  of  the  concern  which 
ships  the  goods.  In  a  case  of  the  latter  kind  the  stable  expense 
is  divided  by  the  tonnage  hauled,  and  the  rate  thus  obtained  is 
multiplied  by  the  number  of  tons  involved  in  the  outward  cartage 
in  order  to  obtain  the  amount  applicable  to  outward  cartage. 

The  relation  of  sales  deductions  to  sales  will  be  seen  in  the 
following  tabulation: 

Gross  sales $100,000.00 

Less  sales  returns 5,000.00 

Net  sales $95,000.00 


Deductions  from  sales: 

Trade  discount $10,000.00 

Allowances : 

Defective  goods $100.00 

Breakage   200.00 

Damage , 300.00 

Loss    400.00 

Rebates 2,000.00 

Outward  freight 3,000.00 

Outward  cartage 500.00 

Total  deductions  from  sales $16,500.00 

Income  from  sales $78,500.00 


In  closing  the  books,  the  various  detail  accounts  will  be  closed 
into  the  group  account,  "income  from  sales,"  which  will  in  turn 
be  closed  into  profit  and  loss. 


158 


CHAPTER   XXV 

THE   COST-OF-SALES   GROUP 

The  cost  of  sales  may  be  generally  divided  into  three  ele- 
ments, namely:  materials  and  supplies,  labor,  and  manufacturing 
overhead.  This  group  corresponds  to  the  expense-of-operation 
group  in  organizations  other  than  a  manufacturing  concern.  The 
materials  and  supplies  include,  in  addition  to  the  gross  purchases, 
inward  freight  and  inward  cartage,  the  latter  item  being  either 
a  direct  charge  for  drayage  or  a  proportion  of  the  stable  expense. 
The  salaries  and  expenses  of  the  purchasing  department  are  also 
properly  chargeable  to  materials  and  supplies. 

The  labor  is  divided  into  direct  and  indirect,  the  latter  con- 
stituting the  wages  of  foremen,  laborers  and  helpers.  Generally 
speaking,  nothing  is  gained  by  classifying  labor  as  direct  and 
indirect.  Where  a  cost  system  obtains,  however,  it  is  desirable 
that  this  classification  should  be  made,  because  of  the  fact  that 
one  of  the  prime  objects  in  cost  accounting  is  to  charge  direct 
to  jobs  as  many  items  as  possible.  The  direct  labor,  constituting 
the  work  of  the  employees  directly  engaged  in  working  upon  the 
product,  is  something  which  can  be  specifically  allocated  to  jobs ; 
the  indirect  labor,  such  as  the  work  of  foremen,  laborers  and 
helpers,  cannot  be  specifically  allocated.  Such  division  of  labor 
facilitates  the  work  of  the  cost  department  and  permits  of  agreeing 
the  cost  records  with  the  general  books,  by  reason  of  the  fact 
that  indirect  labor  is  thrown  into  the  manufacturing  overhead. 
Manufacturing  overhead,  or  factory  expense,  as  it  is  frequently 
called,  includes  superintendence,  salaries  of  clerks  keeping  the 
factory  records,  factory  office  expense,  heat,  light  and  power, 
factory  supplies,  repairs  and  renewals  of  shop  tools  and  minor 
operating  equipment,  depreciation  of  machinery  and  other  major 
operating  equipment,  etc. 

In  cost  accounting,  materials^  and  supplies  and  direct  labor 
are  combined,  and  constitute  what  is  known  as  prime  cost.  Prime 
cost  plus  manufacturing  overhead  equals  manufacturing  cost. 
As  was  previously  pointed  out,  one  of  the  items  included  in  the 
cost  of  materials  was  inward  freight.  Theoretically,  inward 
freight  is  a  part  of  the  cost  of  materials ;  practically,  it  becomes 

159 


Principles  of  Accounting 

almost  impossible  to  connect  the  inward  freight  with  the  items 
of  materials  and  supplies  which  it  covers.  To  do  so  it  would 
be  necessary,  perhaps,  to  distribute  the  freight  corresponding  to 
a  certain  way  bill  over  several  different  invoices.  The  share  of 
freight  thus  pro-rated  to  the  various  invoices  would  have,  in 
return,  to  be  distributed  over  the  various  classes  of  items  making 
up  the  invoice.  The  distribution  to  classes  of  items  having  been 
accomplished,  it  would  then  be  necessary  to  divide  the  amount 
so  ascertained  by  the  number  of  units  pertaining  to  the  particular 
class  in  question,  in  order  to  obtain  a  unit  cost  for  freight.  The 
amount  of  clerical  labor  involved  in  such  calculations  is  so  great 
that  it  is  probable  that  most  concerns  do  not  attempt  such  a  dis- 
tribution in  practice.  It  is  a  widespread  custom  to  include  inward 
freight  in  the  overhead  rather  than  attempt  to  load  it  to  materials 
and  supplies.  The  same  remarks  apply,  possibly  with  greater 
force,  to  inward  cartage.  Theoretically,  it  is  very  properly 
included  in  the  cost  of  materials ;  practically,  it  becomes  a  difficult 
matter  to  do  so.  The  situation  will  be  affected  proportionately 
by  the  conditions  which  exist.  If  a  concern  has  its  own  stable 
organization,  and  does  all  its  own  hauling,  the  stable  expense 
must  first  be  distributed  to  inward  cartage  and  outward  cartage. 
The  proportion  corresponding  to  inward  cartage  will  then  have 
to  be  pro-rated,  presumably  on  a  tonnage  basis,  over  the  incoming 
invoices,  since  it  is  next  to  impossible  to  connect  in  any  other 
way  the  service  rendered  by  the  stable  with  the  materials  and 
supplies  hauled. 

Much  discussion  has  arisen  in  the  past  as  to  the  proper  alloca- 
tion of  the  salaries  and  expenses  of  the  purchasing  department. 
It  has  been  contended,  on  the  one  hand,  that  the  purchasing 
officer  was  an  administrative  officer,  charged  with  exercising  his 
judgment  as  to  purchases,  and  in  no  way  connected  with  the 
technical  or  operating  department  of  the  organization.  As  such, 
the  salaries  and  expenses  of  his  department  would  very  properly 
be  charged  to  administrative  expenses.  On  the  other  hand,  it 
is  contended  that  the  services  of  this  office  are  rendered  entirely 
for  the  benefit  of  the  manufacturing  or  technical  department ;  that 
the  concern  in  question  is  not  engaged  in  buying  and  selling 
materials  and  supplies,  and  that  the  salaries  and  expenses  of 
the  purchasing  department  should  be  charged  into  the  cost  of 
materials  and  supplies,  because  of  the  fact  that  such  services 

i6o 


The  Cost-of-Sales  Group 

and  expenses  were  incurred  in  connection  with  the  materials 
and  supplies  to  be  used  in  the  manufacture  of  goods.  The  latter 
point  of  view  would  seem  to  be  the  most  logical  one.  It  is  true 
that  the  purchasing  officer  exercises,  in  a  way,  both  of  the  func- 
tions above  described.  The  latter,  however,  seems  to  very  greatly 
overshadow  the  former.  The  remarks  which  were  made  with 
regard  to  inward  freight  and  cartage  apply  with  equal  force  to 
the  salaries  and  expenses  of  the  purchasing  department.  Theo- 
retically, they  add  to  the  cost  of  materials  and  supplies;  practi- 
cally, it  is  inexpedient,  on  account  of  the  clerical  work  involved, 
to  pro-rate  them  on  a  unit  basis.  They  are,  accordingly,  included 
in  the  overhead. 

In  connection  with  purchases  there  are  several  classes  of  items 
which  should  be  mentioned.  Prominent  among  these  are  pur- 
chase returns,  trade  discounts,  allowances  and  rebates.  These 
items  bear  the  same  relation  to  gross  purchases  that  sales  returns, 
etc.,  bear  to  gross  sales.  In  short,  they  are  deductions  from 
the  gross  purchases  and  the  result  gives  the  true  cost  of  the 
purchases.  It  will  probably  not  be  necessary  to  discuss  them 
here,  since  similar  items  relating  to  sales  were  discussed  in  the 
preceding  chapter.  Neither  is  it  proposed  to  discuss  here  cash 
discount,  rent  of  factory,  taxes  and  insurance  on  factory  property, 
etc.,  for  the  reason  that  such  items  will  be  discussed  under  a 
separate  group,  entitled  ^'deductions  from  income." 

In  arriving  at  the  cost  of  sales  it  must  be  borne  in  mind  that 
manufacturing  cost  is  not  cost  of  goods  sold.  Manufacturing 
cost  is  affected  by  the  difference  in  inventory  of  goods  in  process 
and  the  difference  in  inventory  of  finished  goods.  The  cost  of 
sales  is  arrived  at  logically  by  beginning  with  materials  and 
supplies,  adding  labor  and  manufacturing  overhead,  allowing  these 
three  items  to  represent  goods  in  process,  which,  when  completed, 
will  be  transferred  to  finished  goods.  As  goods  are  sold  they 
are  charged  to  cost.  This  method,  which  may  be  called  the  direct 
method,  becomes  possible  only  when  there  is  a  cost  system.  Where 
no  cost  system  obtains,  and  it  is  necessary  to  procure  the  informa- 
tion concerning  the  cost  of  sales  from  the  general  books,  it  is 
obtained  by  what  is  known  as  the  inventory  or  indirect  method. 
The  respective  accounts  for  materials  and  supplies,  labor  and 
overhead  are  closed  into  the  account  for  manufacturing.  This 
account  represents  the  goods  in  process.     If  at  the  end  of  the 

i6i 


Principles  of  Accounting 

period  an  inventory  of  goods  in  process  is  taken,  and  this  inven- 
tory is  applied  to  the  manufacturing  account,  the  difference  will 
constitute  the  cost  of  goods  transferred  to  finished  stock.  In  the 
same  way,  if  an  inventory  is  taken  of  the  finished  goods,  and 
this  inventory  applied  at  the  end  of  the  period  to  the  finished 
goods  account  in  the  general  ledger,  the  difference  in  the  account 
will  then  represent  the  cost  of  the  goods  sold. 

An  ideal  manner  of  closing  the  books  where  a  statement  of 
income  and  profit  and  loss  is  to  be  prepared  is  to  open  an  account 
called  "cost  of  sales,"  and  to  close  into  it  the  items  included  in 
this  group.  Beginning  with  the  account  for  materials  and  sup- 
plies, the  first  item  will  constitute  the  difference  in  inventory  of 
materials  and  supplies.  The  subsequent  charges  pertaining  to 
materials  and  supplies  will  be  gross  purchases,  inward  freight, 
inward  cartage  and  the  salaries  and  expenses  of  the  purchasing 
department.  The  credits  pertaining  to  materials  and  supplies 
will  be  purchase  returns,  trade  discounts  on  purchases,  purchase 
allowances  and  purchase  rebates. 

At  this  point  it  may  be  advisable  to  pause  for  a  moment  to 
discuss  a  point  with  regard  to  the  inventory  of  materials  and 
supplies.  There  will  frequently  be  instances  in  which  the  item 
of  inward  freight  is  sufficiently  large  to  justify  setting  up  a  part 
of  this  freight  in  the  inventory.  For  example:  A  foundry 
buying  large  quantities  of  pig  iron,  and  having  to  pay  the  inward 
freight,  would  be  justified  (if  at  inventory  time  there  remained — 
out  of  purchases  of  a  hundred  thousand  tons — eighty  thousand 
tons,)  in  setting  up  in  the  inventory  eight-tenths  of  the  inward 
freight  on  the  pig  iron.  Theoretically,  the  same  thing  applies  to 
inward  cartage,  although  the  items  are  usually  so  small  as  not 
to  warrant  this  procedure. 

Resuming  now  with  the  items  making  up  the  cost  of  sales, 
the  account  for  direct  labor  will  be  closed  into  the  account  "cost 
of  sales."  The  various  items  of  factory  expenses  will  be  treated 
likewise.  The  account  for  goods  in  process  inventory,  which 
showed  the  inventory  on  hand  at  the  beginning  of  the  period, 
will  be  treated  with  the  inventory  on  hand  at  the  end  of  the 
period.  The  difference  in  this  account  will  be  closed  into  the 
cost  of  sales.  In  a  similar  way,  the  account  for  finished  goods 
inventory,  which  showed  on  the  debit  side,  the  inventory  at 
the  beginning  of  the  period  and  on  the  credit  side,  the  inven- 

162 


The  Cost-of-Sales  Group 

tory  at  the  end  of  the  period,  will  be  closed  out  to  the  cost  of 
sales. 

It  will  thus  be  seen  that  the  cost-of-sales  account  will  contain 
the  precise  information  necessary  to  prepare  the  second  section 
of  the  statement  of  income  and  profit  and  loss,  as  follows : 
Materials  and  supplies : 

Gross  purchases $75,500.00 

Less-purchase  returns 500.00 

Net  purchases $75,000.00 

Add — Inward  freight 400.00 

Inward  cartage 200.00 

Salaries  and  expenses  purchasing 

department 1,400.00 

Total  cost  of  purchases $77,000.00 

Deduct — Trade  discounts  on  purchases. .  $500.00 

Purchase  allowance 400.00 

Purchase  rebates 100.00 

Total  deductions $1,000.00 

Net  cost  of  purchases $76,000.00 

(Add  or)  deduct  difference  in  inventory 

materials  and  supplies 5,000.00 

Cost  of  mat'ls  and  supplies  consumed  $71,000.00 

Labor — Direct 25,000.00 

Factory  expense: 

Superintendence 5,000.00 

Labor,  indirect 600.00 

Salaries  of  clerks t 2,000.00 

Factory  office  expense 400.00 

Heat,  light  and  power 750.00 

Factory  supplies 250.00 

Repairs  and  renewals 50.00 

Depreciation  of  machinery,  etc 950.00 

Total  manufacturing  cost $106,000,00 

163 


Principles  of  Accounting 

Add  (or  deduct  increase  or)  decrease  in  in- 
ventory of  goods  in  process 10,000.00 

(Add  or)  deduct  increase  (or  decrease)  in 

inventry  of  finished  goods 85,000.00 

Total  cost  of  sales $31,000.00 


The  second  section  of  the  income  statement  will  not  always 
appear  in  as  great  detail  as  the  above,  for  various  reasons.  Fun- 
damentally, however,  whether  shown  in  detail  or  condensed,  the 
cost  of  sales  remains  as  indicated. 


r64 


CHAPTER   XXVI 

GROSS    PROFIT   ON    SALES   AND   TURNOVER 

Gross  profit  on  sales  forms  the  subject  of  considerable  discus- 
sion in  accounting.  It  is  obtained  by  deducting  the  cost  of  sales 
from  the  income  from  sales.  It  is  the  first,  or  prime,  profit 
obtained  by  placing  against  the  income  derived  from  sales  the 
cost  of  the  goods  themselves.  It  does  not  take  into  consideration 
the  expense  of  selling  the  goods,  the  expense  of  administering 
the  business,  nor  any  expense  in  connection  with  the  obtaining 
or  employment  of  capital.  The  discussion  which  arises  in  con- 
nection with  gross  profit  is  whether  or  not  it  should  be  shown 
in  relation  to  cost  or  to  the  sales  price.  It  is  quite  common  for 
one  to  hear  the  expression,  *'The  gross  profit  is  sixty  per  cent." 
It  is  not  clear,  however,  when  such  a  statement  is  made,  whether 
this  percentage  is  ratio  of  gross  profit  to  cost  or  ratio  of  gross 
profit  to  sales.  A  careful  analysis  of  the  question  fails  to  reveal 
any  specific  advantage  other  than  a  desire  for  uniformity  in 
either  method  of  treatment.  It  has  been  claimed  that  the  ratio 
should  be  based  on  cost,  because  of  the  fact  that  the  volume  of 
sales  is  liable  to  fluctuate  widely.  This  reason  appears  fallacious, 
because  of  the  fact  that  if  sales  fluctuate  cost  should  fluctuate 
accordingly.  That  either  basis  is  correct  so  long  as  it  is  con- 
sistent would  appear  to  be  true.  As  an  illustration,  let  it  be 
supposed  that  the  sales  price  is  $i,ooo,  the  cost  $600,  and  the 
gross  profit  $400.  It  will  then  be  true  that  the  gross  profit  is 
66  2-3  per  cent,  of  the  cost  and  40  per  cent,  of  the  selling  price. 
If  this  one  case  be  multiplied  by  the  great  number  of  transactions 
which  might  be  expected  to  enter  into  the  accounts  of  a  large 
concern  during  the  period  of  a  year  it  will  then  be  seen  that  if 
this  transaction  is  a  typical  one  gross  profits  for  the  year  should 
be  about  66  2-3  per  cent,  of  cost,  or  40  per  cent,  of  sales.  It 
would  seem  to  be  immaterial  which  basis  were  selected.  Statis- 
tics become  valuable  only  when  they  can  be  compared.  In  the 
case  under  discussion  at  present  the  comparison  would  be  either 
with  an  organization  engaged  in  a  similar  line  of  business  or  a 
comparison  of  the  figures  for  this  period  with  those  of  another 
period.    It  would  not  be  consistent  to  compare  the  ratio  of  gross 

i6s 


Principles  of  Accounting 

profits  in  the  case  of  organization  A,  if  this  gross  profit  were 
based  on  cost,  with  the  gross  profit  of  organization  B,  the  gross 
profit  of  which  was  based  on  sales.  Nor  would  it  be  consistent 
to  compare  the  gross  profit  of  this  period,  when  based  on  cost, 
with  the  gross  profit  of  the  next  period  when  based  on  sales. 
The  basis  would  seem  to  be  entirely  a  matter  of  a  simple  arith- 
metical calculation.  Two  and  two  will  make  four;  three  and 
one  will  make  four.  The  ratio  which  either  one  of  the  compo- 
nent parts  bears  to  the  whole  will  change  in  accordance  with 
changes  in  the  component  parts.  Two  is  50  per  cent,  of  four; 
one  is  25  per  cent,  of  four;  while  two  is  100  per  cent,  of  two, 
and  one  is  50  per  cent,  of  two.  If  four  changes  to  five,  or  even 
six,  the  relation  of  two  and  one,  respectively,  to  either  five  or 
six  will  change.  If  the  sales  increase  and  the  cost  remains  con- 
stant, the  ratio  of  gross  profits  to  sales  will  increase.  If  sales 
decrease,  and  the  cost  remains  fixed,  the  ratio  of  gross  profits 
to  sales  will  decrease.  This  situation,  however,  is  largely  theo- 
retical, because  when  sales  increase  or  decrease  they  are  usually 
attended  by  a  corresponding  increase  or  decrease  in  the  cost. 
The  reverse  would  usually  be  true.  If  cost  increases  or  decreases, 
it  should  be  due  to  increase  or  decrease  in  sales.  The  percentage 
of  gross  profits,  whether  determined  on  cost  or  sales  basis,  should 
not  be  affected  fundamentally  by  fluctuations  in  either  cost  or 
sales. 

Some  time  ago  a  trade  journal  published  an  article  by  a 
representative  of  one  of  the  largest  manufacturing  concerns  in 
the  country.  The  article  occupied  four  columns  of  space.  It 
was  based  on  the  following  question:  "A  certain  article  cost 
$1.00  wholesale.  What  will  it  have  to  be  sold  for  to  allow  a 
profit  of  10  per  cent,  after  allowing  22  per  cent,  for  cost  of  doing 
business?"  It  was  said  to  be  a  very  simple  question,  and  one 
that  every  retailer  has  to  answer  in  his  own  business  every  day, 
but  that  seven  hundred  and  fifty  out  of  one  thousand  retailers 
answered  it  wrong.  One  thousand  retailers  would  probably  have 
answered  the  question  correctly  if  it  had  been  a  fair  one.  It  is 
a  slight  reflection  on  the  intelligence  of  seven  hundred  and  fifty 
retailers  that  they  were  not  sharp  enough  to  ask  the  question, 
"Is  the  profit  of  10  per  cent,  on  sales  or  on  cost?"  and  it  would 
appear  to  be  merely  a  coincidence  that  two  hundred  and  fifty 
out  of  the  one  thousand  arbitrarily  selected  the  sales  basis.     It 

166 


Gross  Profit  on  Sales  and  Turnover 

IS  not  at  all  improbable  that  the  whole  proposition  was  an  adver- 
tising scheme,  simply  to  involve  retailers  in  discussion  and  attract 
attention  to  the  concern  which  propounded  the  question.  It 
serves  here,  however,  to  illustrate  the  importance  which  attaches 
to  the  subject.  The  only  objection  that  the  author  knows  to 
using  the  sales  basis  is  that  the  transaction  will  never  show 
loo  per  cent,  profit.  Just  as  soon  as  the  elements  of  cost  and 
expense  are  introduced  into  a  sale  it  becomes  impossible  to  make 
loo  per  cent,  of  profit  on  the  sale.  Frankly,  this  does  not  seem 
to  constitute  a  consistent  objection  to  this  method.  The  cost 
method  seems  the  more  logical,  however,  since  the  ordinary 
merchant,  in  fixing  a  price  upon  his  goods,  begins  with  their 
prime  cost,  and  adds  the  expense  of  selling  them  and  the  expense 
of  administration,  etc.  To  all  of  these  he  then  adds  the  per- 
centage of  profit  which  he  desires  to  realize,  and  such  figures 
constitute  his  selling  price.  Cost  necessarily  precedes  selling 
price.  Hence  it  would  seem  illogical  for  a  man  to  settle  upon 
a  selling  price  and  then  deduct  the  profit  which  he  desires  to 
make,  in  order  to  ascertain  what  his  cost  is  to  be. 

The  percentage  of  gross  profit  is  undoubtedly  a  valuable 
means  of  presenting  comprehensive  information  as  to  profits.  A 
certain  line  of  goods  showing  a  gross  profit  of  60  per  cent,  for 
the  present  year  should,  under  precisely  similar  conditions,  show 
the  same  percentage  of  gross  profit  during  the  next  year.  If 
the  gross  profit  is  different,  then  the  cause  must  be  sought  in 
one  of  two  places — sales  or  cost.  If  the  sales  have  increased 
during  this  period  as  compared  with  the  next  preceding,  whereas 
the  cost  has  remained  practically  the  same,  the  cause  of  the  in- 
crease in  profits  may  be  traced  either  to  lower  purchase  prices  or 
a  greater  number  of  completed  sales  without  returns  or  allow- 
ances. This  indicates  good  judgment  and  efficiency  on  the  part 
of  both  the  purchasing  and  sales  departments.  If  the  sales  have 
decreased  while  the  cost  remains  constant  the  reverse  might 
be  true.  Sales  remaining  the  same,  with  costs  either  increasing 
or  decreasing,  might  mean  lack  of  initiative  or  ability  on  the 
part  of  the  sales  force  with  either  an  increase  or  decrease  in 
the  efficiency  of  the  purchasing  and  manufacturing  departments, 
in  accordance  with  either  the  increase  or  decrease  in  the  cost  of 
the  goods. 

Statistics  of  this  nature  are  not  conclusive.    They  are  merely 

167 


Principles  of  Accounting 

indicative.  Without  them  the  situations  such  as  have  just  been 
described  would,  perhaps,  never  be  thought  of.  They  are  expe- 
dients which  are  inexpensive  and  at  the  same  time  valuable. 
They  are  made  use  of  very  largely  by  organizations  constructed 
on  a  departmental  basis,  for  judging  the  capacity  and  ability 
of  heads  of  departments.  They  give  clues,  so  to  speak,  which 
may  be  investigated,  and  point  the  way  to  information  which 
may  be  of  real  value  to  the  administrative  force.  The  author 
remembers  one  case  in  which  an  expedient  growing  out  of  sus- 
picions aroused  by  decreasing  gross  profits  was  resorted  to  to 
apprehend  a  bartender  who  was  suspected  of  failing  to  account 
for  all  the  liquor  which  he  dispensed  over  the  bar  and  instead 
putting  a  part  of  the  proceeds  into  his  own  pocket.  Acting  on 
the  suspicion,  a  series  of  tests  were  made  to  determine  approxi- 
mately what  the  gross  profit  on  the  various  kinds  of  liquors  should 
be.  It  was  ascertained  that  a  bottle  of  whiskey  contained  approxi- 
mately so  many  drinks,  which  could  be  sold  for  fifteen  cents  each. 
The  sale  price  of  a  bottle  of  whiskey  was,  therefore,  ascertained. 
It  was  known  what  the  whiskey  cost.  Thus  it  became  possible 
to  determine  the  gross  profit  and  the  ratio  of  gross  profit  to  cost. 
Similar  tests  were  made  with  beer,  fancy  drinks  and  bottled 
goods.  These  being  used  as  a  basis  for  judging  the  entire  sales 
of  the  bar,  when  the  usual  calculations  for  the  subsequent  month 
showed  the  cost  of  sales  respectively,  it  was  an  easy  matter  to 
apply  the  respective  percentages  of  gross  profit  and  ascertain 
the  approximate  amount  of  sales  for  the  month.  When  the  sales 
reported  and  accounted  for  fell  far  short  of  this  amount  the 
management  had  little  hesitancy  in  charging  the  bartender  with 
the  irregularity,  which  he  admitted. 

The  establishment  of  inventories  by  the  gross  profit  method  is 
frequently  resorted  to  in  the  settlement  of  fire  losses.  Suppose, 
for  example,  that  a  fire  occurs  at  some  time  other  than  that  at 
which  the  inventory  has  just  been  taken.  Unless  detail  stock 
records  have  been  kept  and  preserved  the  amount  of  stock  on  hand 
at  the  time  of  the  fire  must  be  approximated.  Sales  records  will 
in  most  cases  be  intact  because  of  having  been  put  away  in  the 
safe.  From  such  records  or  the  sales  account  in  the  general 
ledger  or  both  the  sales  since  the  last  physical  inventory  may  be 

i68 


Gross  Profit  on  Sales  and  Turnover 

established.  The  application  of  the  average  gross  profit  for  three 
or  five  years  next  preceding  the  fire  will  give  a  fair  approxima- 
tion of  the  cost  of  the  goods  sold  since  the  last  inventory.  With 
this  information  available  a  fairly  accurate  estimate  of  the  inven- 
tory at  the  time  of  the  fire  may  be  obtained.  Normally,  inventory 
at  the  beginning  of  the  period,  plus  purchases, — less  inventory  at 
the  end — equals  cost  of  goods  sold.  From  this  it  follows  logically 
then,  that  the  inventory  at  the  beginning  of  the  period  plus  the 
purchases — less  the  cost  of  the  goods  sold — equals  the  inventory 
at  the  end  of  the  period,  which  in  the  case  in  question  means  the 
date  of  the  fire.  Such  is  the  manner,  making  due  allowance  for 
the  goods  in  process,  in  which  the  estimated  value  of  the  stock  is 
arrived  at  and  becomes  the  basis  for  fixing  the  amount  of  the  loss. 

Turnover  is  a  term  sometimes  applied  to  the  cost  of  sales.  It 
is  a  term  which  has  come  into  use  in  connection  with  accounting, 
and  constitutes  one  of  the  many  technical  expressions  which 
might  better  be  avoided.  When  one  uses  the  expression  "cost 
of  sales"  every  one  understands  what  is  meant.  When  one  uses 
the  expression  "turn-over,"  a  discussion  usually  arises  as  to 
whether  cost  of  sales  or  something  else  is  meant.  Mr.  R.  H. 
Montgomery,  C.P.A.,  in  his  book  on  "Auditing,"  suggests  the 
following  definition,  in  which  the  author  concurs :  "The  turn- 
over of  a  merchant  or  manufacturer  represents  the  number  of 
times  his  capital,  in  the  form  of  stock  in  trade,  is  reinvested  in 
stock  in  trade  during  a  given  period."  Mr.  Montgomery  gives 
the  following  formula  for  ascertaining  the  turn-over:  "Take 
the  starting  inventory,  add  the  purchases  or  cost  of  manufac- 
tured goods,  and  deduct  the  inventory  at  the  end.  Divide  the 
total  by  the  starting  inventory.  The  result  will  be  the  number 
of  times  the  capital  invested  in  stock  in  trade  has  been  turned 
over  during  the  period." 

It  will  be  seen  that  this  expedient  may  also  be  used  to  gauge 
the  efficiency  of  heads  of  departments  in  a  concern  such  as  a 
department  store.  The  number  of  times  which  the  stock  has 
been  turned  over  will  indicate  the  efficiency  of  the  sales  force. 

In  a  large  retail  shoe  store  in  New  York  City,  which  is 
organized  on  a  departmental  basis,  the  turn-over  is  ascertained 
monthly  with  regard  to  each  department  and  is  useful  in  admin- 

169 


Principles  of  Accounting 

istering  the  business.  If  the  goods  in  a  given  department  have 
not  been  turned  over  as  many  times  as  they  should  have,  an  in- 
quiry is  made  to  determine  the  cause.  Failure  may  be  due  to 
a  falling  off  in  the  demand  for  the  goods  offered  by  that  particular 
department,  or  by  failure  of  clerks  to  satisfy  the  requirements 
of  customers.  A  little  attention  is  then  given  to  the  department 
in  question,  with  a  view  to  ascertaining  the  specific  cause.  If 
the  trouble  is  found  to  rest  with  the  clerks,  the  inefficient  clerks 
are  eliminated.  A  practical  application  of  the  turn-over  is  best 
seen  in  organizations  similar  to  the  one  just  mentioned,  where 
the  operations  can  be  localized  and  circumscribed  in  departments. 

The  margin  of  profit  on  merchandise  frequently  depends  upon 
the  number  of  times  it  may  be  turned  over.  Almost  everyone 
in  New  York  City  is  familiar  with  candy  at  a  "penny  a  pound 
profit."  A  penny  a  pound  would  represent  an  insignificant  profit 
if  it  were  not  for  the  great  number  of  pounds  sold.  No  doubt  if 
one  were  to  ask  of  this  manufacturer  how  he  can  afford  to  do  busi- 
ness on  this  basis  he  would  reply  "because  I  am  able  to  turn  my 
money  over  so  quickly."  The  goods  are  sold  for  cash  and  the 
profit  realized  as  soon  as  the  goods  are  sold. 

A  merchant  with  a  stock  of  $10,000  which  he  sells  at  a  profit 
of  2%  will,  if  he  sells  such  a  quantity  and  value  of  merchandise 
six  times  in  the  course  of  a  year,  be  at  the  end  of  the  year  in  the 
same  position  with  regard  to  profits  as  the  man  who  sells  $20,000 
worth  of  merchandise  at  6%.  Each  will  have  made  a  profit  of 
$1,200.  Calculate  the  position  of  the  respective  merchants  if 
each  is  obliged  to  borrow  his  entire  capital  at  4%.  The  first  one 
will  realize  a  net  profit  of  $800  while  the  second  realizes  a  net 
profit  of  $400. 

The  suggestion  of  interest  raises  a  question  which  might  prop- 
erly accur  to  one  giving  thought  to  the  subject.  "Is  the  turnover 
dependent  upon  the  realization  of  profit  in  the  form  of  cash  ?"  In 
answer  it  may  be  said  that  it  is  not.  Profit  is  the  difference  be- 
tween the  cost  and  selling  price  of  goods  and  may  appear  as  vested 
in  cash,  accounts  or  notes  receivable,  etc.  When  the  goods  have 
been  sold  or  turned  over  the  profit  arises  even  though  not  collected. 
If  goods  are  sold  on  credit,  it  is  to  be  presumed  that  they  may  be 
purchased  on  credit  and  on  terms  equivalent  to  those  on  which 

170 


Gross  Profit  on  Sales  and  Turnover 

they  are  sold.  If  necessary  to  borrow  funds  with  which  to  finance 
the  transaction,  the  expense  of  interest  will  serve  to  decrease  the 
amount  of  profit.  Such  a  situation  must  not  be  overlooked  by 
the  administration  in  planning  the  financial  operations,  but  it 
should  not  be  permitted  to  cloud  the  principal  issue  with  regard 
to  the  turnover. 

REFERENCES  FOR  COLLATERAL  READING: 

Journal  of  Accountancy,  Vol.  XII,  page  346. 


171 


CHAPTER    XXVII 

THE   SELLING-EXPENSE   GROUP 

This  group  comprises  the  expenses  relating  to  the  sales  de- 
partment, advertising,  and  such  miscellaneous  expense  as  enter- 
taining customers.  The  sales  department  expenses  may  be  divided 
into  those  having  to  do  with  the  office  and  those  of  the  salesmen. 
The  office  expenses  will  consist  of  the  salaries  of  the  sales 
manager  and  clerks  as  well  as  the  miscellaneous  office  expenses. 
The  expenses  of  the  salesmen  will  include  salaries,  traveling 
and  commissions.  There  is  nothing  especially  peculiar  concern- 
ing the  salaries  of  the  sales  manager  and  clerks.  At  times,  the 
amount  chargeable  to  the  salary  of  the  sales  manager  is  a  part 
of  the  salary  of  some  officer  of  the  company  whose  time  is  in 
part  devoted  to  selling  and  the  management  of  the  sales  depart- 
ment. Neither  do  the  salaries  of  the  salesmen  call  for  any 
particular  comment.  Traveling  expenses  will  include  all  expenses 
from  the  time  the  salesman  leaves  the  office  until  he  returns 
from  his  trip.  Most  concerns  require  detailed  expense  reports 
from  their  salesmen,  classifying  the  expenses  into  traveling,  sub- 
sistence and  miscellaneous.  Traveling  includes  the  car  or  taxicab 
which  takes  the  salesman  from  the  office  to  the  train,  his  railroad 
fare  to  point  of  destination,  including  Pullman  and  meals  on 
the  train;  also  the  cab  or  car  from  the  station  at  destination  to 
the  hotel.  Subsistence  covers  his  board  and  lodging  at  the 
hotel,  while  miscellaneous  expenses  cover  items  like  stationery, 
telegrams,  etc.  It  is  quite  the  custom  to  advance  funds  to 
salesmen  for  traveling  expenses,  the  funds  to  be  accounted  for 
either  monthly,  or  at  the  end  of  each  trip  if  the  traveling  is  not 
continuous.  Where  a  salesman  is  constantly  on  the  road,  the 
fund  is  carried  the  same  as  the  ordinary  working  fund.  He 
will  be  advanced  a  sufficient  amount  to  cover  his  expenses  for 
the  month,  for  example.  At  the  end  of  each  month  he  sends 
in  his  expense  report,  and  receives  in  return  a  check  in  the  same 
amount.  Thus,  on  the  books  of  the  general  office  he  will  at  all 
times  be  charged  with  the  amount  of  his  fund. 

A  salesman  may  receive  not  only  salary  but  commission  for 
his  services.     In  some  cases,  salesmen  work  entirely  on  com* 

172 


The  Selling-Expense  Group 

missions.  In  both  these  cases  a  somewhat  unique  question  fre- 
quently presents  itself.  To  illustrate  the  point,  take,  for  example, 
the  straw  hats  which  will  be  sold  by  retailers  during  the  coming 
spring  and  summer.  These  same  goods  were  probably  sold  by 
salesmen  representing  wholesalers  who  were  on  the  road,  com- 
pleted their  sales,  received  their  salaries,  traveling  expenses  and 
commissions  prior  to  December  31.  The  question  which  arises 
is  this :  "Is  it  proper  to  charge  such  expenses  against  one  year, 
although  contracts  for  delivery  are  made  in  that  year,  when  the 
actual  delivery  of  the  goods  will  not  be  made  and  sales  recorded 
until  the  subsequent  year?"  Theoretically,  it  is  not  correct  to 
do  so,  for  the  reason  that  while  legally  the  sale  was  made  during 
one  year  the  sales  were  not  recorded  as  such,  in  so  far  as  the 
operations  of  the  business  are  concerned,  until  a  subsequent 
year.  Theoretically,  the  income  of  the  subsequent  year  profited 
by  the  sales.  It  would  also  seem,  as  a  matter  of  justice,  that  it 
should  be  charged  with  the  expenses  attending  these  sales.  Cases 
have  been  known  where  concerns  attempted  to  suspend  salaries 
and  expenses  of  salesmen  and  apply  them  against  the  period 
in  which  the  sales  were  recorded.  In  the  majority  of  cases, 
however,  it  is  held  that  one  period  will  offset  another,  or  that 
the  matter  will  be  evened  up  in  the  long  run,  and  it  is  generally 
a  waste  of  time  and  effort  to  carry  these  items  in  suspense  and 
apply  them  properly. 

Commissions  are  usually  computed  on  sales  prices.  In  some 
cases  they  are  credited  to  the  salesman's  drawing  account,  against 
which  advances  are  charged.  It  becomes  necessary  in  some 
cases  to  keep  elaborate  records  of  commissions,  because  of  the 
tendency  on  the  part  of  salesmen  to  put  through  orders  which 
are  not  bona  fide,  and  in  that  way  attempt  to  collect  larger 
commissions  than  they  are  entitled  to.  Concerns  which  have 
commission  contracts  with  their  salesmen  are  put  to  no  end  of 
trouble  many  times  through  returns  and  cancellations.  Most 
concerns  pay  commissions  to  salesmen  only  on  sales  which  mate- 
rialize, or,  in  other  words,  net  sales.  Real  estate  concerns  and 
insurance  companies  which  employ  salesmen  and  agents  espe- 
cially require  elaborate  books  and  records  dealing  with  commis- 
sions. The  subject  of  agents'  commissions  in  the  insurance  line 
is  sufficient  for  a  small  book  in  itself.  It  may  be  mentioned,  in 
passing,  that  the  principal  distinction  to  be  borne  in  mind  by 

173 


Principles  of  Accounting 

insuratice  companies  is  the  payment  of  commissions  on  first-year 
premiums  and  renewal  premiums.  The  rate  differs  on  the  two 
classes  of  premiums,  being  much  greater  in  the  case  of  first-year 
than  in  the  case  of  renewals.  It  is,  therefore,  important  that  the 
company  distinguish  between  the  two. 

Advertising  is  one  of  the  most  important  items  in  this  group. 
Advertising  may  embrace  several  different  forms,  namely,  the 
display  of  advertisements  in  newspapers  and  magazines,  the 
display  of  advertisements  on  billboards,  circular  letters,  souvenirs, 
etc.  It  was  also  suggested  to  the  author  on  one  occasion  that 
the  cost  of  a  sign  be  charged  to  advertising.  To  this  no  particu- 
lar exception  could  be  taken.  Surely  no  one  would  object  to 
charging  the  expense  of  operating  an  electric  sign  to  advertising, 
and  the  question  of  charging  the  cost  of  the  sign  would,  in  either 
case,  not  be  whether  or  not  it  was  approximately  chargeable  to 
advertising,  but  as  to  whether  or  not  it  was  desired  to  capitalize 
an  item  of  such  considerable  cost.  A  well-known  department 
store,  which  maintains  an  auditorium  and  an  entertainment  daily 
for  its  patrons,  charges,  it  is  understood,  the  expense  of  con- 
ducting this  feature  of  the  store  to  advertising.  Any  legitimate 
expense  having  to  do  directly  with  advertising  may  properly  be 
charged  to  the  advertising  account.  The  account  has,  however, 
in  some  instances,  become  a  general  dumping-ground  for  mis- 
cellaneous items — not  excepting  rebates.  One  instance  is  recalled 
in  which  a  small  concern,  doing  practically  no  direct  advertising, 
had  an  expense  account  for  advertising  (rebates)  running  into 
thousands  of  dollars.  While  this  procedure  was  not  illegal  at 
the  time  it  occurred,  it  was  not  justified.  The  proprietor  attempted 
to  justify  it  on  the  theory  that  this  was  one  means  of  attracting 
customers.  The  fallacy  of  such  theory  will  be  apparent  after 
a  moment's  thought. 

The  question  of  vital  importance  with  regard  to  advertising 
is,  first,  whether  or  not  it  is  prepaid;  and  second,  if  prepaid,  in 
what  manner  and  at  what  rate  is  it  used?  A  concern  engaged 
in  circularizing  would  not  be  warranted,  according  to  the  best 
accounting  practice,  in  charging  immediately  to  expense  the 
cost  of  printing  250,000  circular  letters  and  envelopes.  It  would 
be  proper,  rather,  to  charge  these  letters  and  envelopes  to  expense 
approximately  as  used.  The  rule  is  to  charge  advertising,  not 
to  the  period  in  which  it  is  contracted  for,  or  paid  for,  but  to 

174 


The  Selling-Expense  Group 

the  period  in  which  it  is  used.  Thus,  an  organization  contracting 
for  $30,000  worth  of  advertising  for  a  given  year  would  not 
charge  the  entire  $30,000  to  expense  immediately,  nor  at  the 
time  of  paying  for  the  advertising,  but  at  the  rate  of  $2,500  a 
month,  if  the  advertising  were  to  be  spread  over  a  period  of  a 
year.  The  value  of  prepaid  advertising,  in  the  case  of  enforced 
realization  and  liquidation,  will  depend  upon  the  arrangements 
which  can  be  made  with  the  advertising  media  or  agents. 

The  accounts  representing  the  items  making  up  this  group 
are  closed  into  the  account,  "selling  expenses,"  which  account 
corresponds  to  the  third  section  of  the  statement  of  income  and 
profit  and  loss,  as  follows: 

Sales  department  expenses : 

Salary,  sales  manager $2,000.00 

Salaries  of  clerks 1,500.00 

Office  expenses 500.00 

Salesmen : 

Salaries 1,000.00 

Traveling 1,000.00 

Commissions  1,000.00 

Advertising 2,500.00 

Entertainment  of  customers 500.00 

Total  selHng  expenses $10,000.00 


175 


CHAPTER   XXVIII 

THE  ADMINISTRATIVE-EXPENSE   GROUP 

The  principal  items  making  up  this  group  are  salaries  of 
officers,  salaries  of  clerks  (keeping  general  records),  directors' 
fees,  printing  and  stationery,  postage,  telephone  and  telegraph, 
traveling  of  officers  and  clerks,  legal  expenses  and  miscellaneous 
office  expenses.  It  has  been  held  by  some  that  the  title  of  this 
group  should  be  made  broader,  and  called  administrative  and 
general  expense.  It  has  seemed  to  the  author  that  this  is  entirely 
unnecessary,  because  of  the  fact  that  any  item  of  expense,  general 
in  its  nature,  is,  of  necessity,  a  matter  of  administration,  since 
it  does  not  apply  specifically  to  the  manufacture  nor  to  the  sale 
of  the  goods,  but  rather  to  the  administration  of  the  business. 
It  is,  therefore,  thought  that  administrative  expense  is  sufficiently 
broad. 

With  regard  to  the  above  items,  it  may  be  said  that  in  certain 
large  organizations  the  internal  scheme  of  functional  adminis- 
tration throws  a  peculiar  light  upon  them.  Such  an  organization 
may  have  an  internal  division  of  administration  corresponding 
to  the  offices  of  the  president  and  vice-president,  comptroller  or 
auditor,  secretary,  treasurer,  general  solicitor,  etc.  The  account- 
ing department  will  naturally  be  presided  over  by  the  comptroller 
or  auditor.  The  cashier  will  naturally  be  subsidiary  to  the  treas- 
urer. Under  such  an  arrangement  the  administrative  expense 
may,  with  respect  to  each  department,  be  divided  on  the  original 
records  into  salaries  and  expenses.  It  is  not  uncommon  to  find 
separate  pay-rolls  for  the  various  offices  above  mentioned.  It  is, 
however,  uncommon  to  find  expenses  so  treated.  As  a  rule,  office 
expenses  originate  on  the  general  books  rather  than  with  the 
various  offices,  and  are  charged  direct  to  the  general  adminis- 
trative office  expense  account  in  the  general  ledger.  The  salaries, 
likewise,  while  they  may  be  kept  on  separate  pay-rolls  for  the 
purpose  of  classifying  them,  with  regard  to  the  various  offices, 
are  usually  charged  collectively  to  the  salaries  account  in  the 
general  ledger.  While  it  may  be  desirable  in  some  cases,  as  a 
matter  of  cost  concerning  the  running  of  the  various  offices,  to 
distribute  salaries  and  expenses,  such  distribution  should  be  made 

176 


The  Administrative-Expense  Group 

a  matter  of  subsidiary  treatment,  and  should  not  be  taken  cog- 
nizance of  on  the  general  books. 

It  is  evident  that  many  of  the  items  appearing  in  this  group 
will  be  subject  to  accrual.  It  is  doubtful,  however,  if  many 
concerns  give  attention  to  this  matter  in  closing.  This  is  prob- 
ably due  to  the  fact  that  the  amounts  involved  are  usually  small 
and  unimportant,  and  it  is  not  considered  worth  while  to  bother 
with  them.  The  most  striking  exception  to  this  general  state- 
ment is  probably  salaries  of  officers  and  clerks.  This  is  due 
to  the  fact  that  the  salary-roll  may,  at  times,  be  of  considerable 
(size  and  the  salaries  paid  weekly.  It  is  not  so  apt  to  be  true 
in  the  case  of  salaries  of  officers  as  in  salaries  of  clerks.  Salaries 
of  officers  are,  as  a  rule,  paid  by  the  month,  while  salaries  of 
clerks  are  apt  to  be  paid  weekly.  Where  the  clerks'  roll  is  of 
sufficient  size,  and  the  end  of  the  month  happens  to  fall  on 
Thursday,  or  Friday,  it  might  be  worth  while  to  accrue  the 
salaries  for  the  period  intervening  between  the  end  of  the  month 
and  the  previous  Saturday. 

Separate  accounts  should  be  maintained  in  the  general  ledger 
for  salaries  of  officers  and  salaries  of  clerks.  This  is  objected 
to  at  times  by  the  officers,  who  do  not  wish  to  see  the  disparity 
in  amounts  which  may  result  from  an  overloaded  salary-roll  for 
officers.  It  is  well,  however,  to  bear  in  mind  that  financial  state- 
ments are  sometimes  required  for  presentation  to  stockholders, 
and  such  division  facilitates  the  preparation  of  a  comprehensive 
statement  in  this  respect.  Stockholders  may  be  especially  inter- 
ested in  seeing  the  relation  which  salaries  of  officers  bear  to 
salaries  of  clerks,  even  though  the  officers  are  not  interested  in 
this  information. 

Directors'  fees,  while  of  the  same  general  nature  as  salaries, 
should  be  kept  separate.  Fees  are  paid  to  directors  for  services 
in  attending  directors'  meetings.  The  directors,  as  representa- 
tives of  the  stockholders,  may,  through  their  attendance  at  the 
meetings,  assist  in  the  formulation  of  the  company's  policies. 
While  they  receive  compensation  for  these  services,  the  com- 
pensation is  based  upon  attendance  at  meetings,  and  is  slightly 
different  from  a  salary  which  is  paid  for  regular  and  continuous 
service. 

Printing  and  stationery,  as  well  as  the  other  items  appearing 
in  this  group,  such  as  postage,  telephone  and  telegraph,  permit 

177 


Principles  of  Accounting 

of  little  discussion  at  this  time.  Printing  and  stationery,  like 
postage,  may  be  a  direct  charge  to  the  expense  account,  in  accord- 
ance with  its  consumption,  or  as  a  balance  remaining  in  the 
account  after  inventory  for  these  items  has  been  deducted  and 
set  up  as  an  asset.  Telephone  bills  are  usually  rendered  for 
the  month,  in  advance,  and,  of  course,  should  not  be  accrued. 
It  will  rarely  occur  that  they  have  been  paid  in  advance.  What 
usually  happens,  however,  is  that  telephone  bills  for  a  given 
month  in  advance  will  contain  also  the  calls  of  the  preceding 
month  in  excess  of  the  number  stipulated  in  the  contract,  and 
any  long-distance  charges.  While  these  latter  items  are  tech- 
nically a  liability  at  the  end  of  the  preceding  month,  they  are 
usually  so  small  in  amount  as  to  not  warrant  any  attempt  to 
provide  for  their  accrual. 

There  may  be  times  when  it  becomes  necessary  to  draw  the 
line  between  periods  with  precision,  and  at  such  times  it  may 
be  necessary  to  charge  excess  calls  and  long-distance  charges  to 
the  preceding  month,  in  which  they  belong.  Telegraph  bills  are 
usually  rendered  after  the  month  in  which  the  service  has  been 
rendered,  and,  if  precision  is  to  be  maintained,  will  have  to  be 
provided  for  through  accrual  at  the  end  of  the  month. 

Traveling  expenses  of  officers  and  clerks  are  to  be  distin- 
guished from  traveling  expenses  of  salesmen.  The  latter  is,  of 
course,  chargeable  to  the  appropriate  account  in  the  selling- 
expense  group.  The  importance  of  making  this  distinction  will 
be  evident  when  it  is  observed  that  the  traveling  of  officers  may, 
at  times,  be  somewhat  heavy,  and  unless  this  distinction  were 
made  the  salesmen's  expenses  would  be  unduly  laden.  This  trans- 
gression might  be  especially  apparent  where  a  concern  maintains 
a  staff  of  traveling  auditors.  It  is  quite  probable  that  the  traffic 
department  of  a  railroad  would  object  to  being  charged  with  the 
expenses  of  the  company's  traveling  auditors. 

Legal  expenses  may  be  the  expenses  of  conducting  a  legal 
department,  retainers  paid  to  counsel,  or  charges  for  legal  services 
occurring  irregularly.  In  connection  with  the  last  item  it  may 
be  remarked  that  under  certain  circumstances,  where  retainers 
are  of  sufficient  size,  they  may  be  taken  into  consideration  in 
closing  the  books,  and  the  unearned  proportion  set  up  as  a 
deferred  charge  to  expense. 

Miscellaneous  office  expenses  will  include  such  items  as  sundry 

178 


The  Administrative-Expense  Group 

office  supplies,  maintenance  of  office  equipment,  and  dinners  for 
clerks  working  evenings.  It  is,  of  course,  probably  true  that 
the  overtime,  if  any,  paid  to  such  men  should  be  charged  to 
the  salary  account,  and  there  is  no  reason,  as  a  matter  of  exact- 
ness, perhaps,  why  dinner  money  should  not  also  be  charged  to 
the  salary  account.  It  is  thought  to  be  the  general  custom,  how- 
ever, to  charge  this  latter  item  to  the  office  expenses. 

Having  exhausted  by  classification  the  majority  of  items  which 
appear  ordinarily  in  the  administrative-expense  group,  there  are 
still  certain  expenses  which  have  not  been  included,  and  which, 
in  the  opinion  of  the  author,  should  appear  in  this  group.  Such 
items  are  usually  referred  to  as  general  expenses,  and  seem 
to  be  the  principal  reason  advanced  by  parties  who  so  contend 
for  making  the  general  title  of  this  group  "administrative  and 
general  expenses."  The  particular  items  in  mind  are  those, 
such  as  donations,  gratuities  to  employees,  bonuses  at  Christmas 
time,  and  miscellaneous  gratuities  to  outsiders  whereby  the  com- 
mercial comfort  and  work  of  the  company  is  facilitated.  Gratui- 
ties to  employees  may  be  dismissed  with  a  word,  namely,  that 
such  expenses  are  equivalent  to  an  addition  to  the  salary  or 
wage  of  the  employee.  It  would  seem  that  there  should  be  no 
reason  for  excluding,  or  considering  separately,  bonuses  and 
gratuities  to  outsiders,  since  administrative  expense  is  intended 
to  cover  not  only  the  direct  administrative  expenses  but  the 
expenses  of  the  administration.  It  is  true  that  they  might  be 
somewhat  general  in  their  nature,  and  not  possible  of  inclusion 
in  the  classification  thus  far  presented.  They  are,  however, 
expenses  which  are  considered  necessary  to  the  welfare  of  the 
company,  and,  on  account  of  being  incurred  by  administrative 
officers  for  the  benefit  of  the  company,  may  be  logically  included 
as  administrative  expenses.  A  donation  to  a  fire  department 
by  a  concern  having  a  plant  located  in  New  Jersey,  or  a  donation 
to  a  local  Y.  M.  C.  A.,  would  seem  not  to  be  without  the  scope 
of  argument  in  favor  of  treating  such  items  as  administrative 
expenses,  since  on  the  one  hand  the  company  may  expect  to 
receive  indirect  benefit  from  its  contribution  to  the  fire  depart- 
ment, and,  in  the  same  way,  indirect  benefit  through  its  employees 
from  its  contribution  to  the  Y.  M.  C.  A.  A  donation  to  charity 
seems  to  be  the  item  on  which  most  of  the  argument  against  the 
inclusion  of  such  general  items  in  administrative  expense  rests. 

179 


Principles  of  Accounting 

It  IS  claimed  that  no  benefit,  direct  or  indirect,  accrues  to  the 
company  from  such  a  donation.  This,  however,  seems  small 
ground  for  argument,  since  it  must  be  admitted,  it  seems,  that 
the  company  would  not  make  such  donation  except  it  expected 
to  be  held  somewhat  in  esteem  through  its  general  interest  in 
the  affairs  of  the  community,  for  which  reason  such  an  expense 
would  seem  to  be  pertinent  to  the  administration  of  the  company's 
affairs. 

The  items  comprising  this  group,  which  constitute  the  fourth 
section  of  the  income  statement,  and  which  appear  below  in 
tabular  form,  will,  in  closing  the  books,  be  closed  out  to  the 
group  account  administrative  expense: 

Salaries  of  officers $10,000.00 

Salaries  of  clerks 5,000.00 

Directors'  fees. 200.00 

Printing  and  stationery 400.00 

Postage 300.00 

Telephone  and  telegraph 200.00 

Traveling  of  officers  and  clerks 500.00 

Legal  expenses 2,000.00 

Miscellaneous  office  expenses 250.00 

General  expenses 150.00 

Total  administrative  expense $19,000.00 


180 


CHAPTER   XXIX 

THE  SECONDARY-INCOME  GROUP 

In  the  same  manner  that  deducting  cost  of  sales — from  income 
from  sales — produced  gross  profit  on  sales,  so  the  deduction  of 
cost  of  sales,  plus  selling  and  administration  expenses,  from  in- 
come from  sales  produces  net  profit  on  sales.  This  profit,  in  the 
case  of  a  manufacturing  and  selling  organization,  is  known  as  the 
income  from  operations.  It  corresponds  to  the  income  derived  in 
a  railroad  company  through  deducting  operating  expenses  from 
operating  revenues. 

In  the  modern  conception  of  organization  and  its  attendant 
operations  capital  is  the  medium  through  which  the  business  is 
transacted.  Just  as  money  is  the  medium  for  exchange  of  values, 
so  capital  is  the  medium  for  the  transaction  of  business.  Theo- 
retically, the  capital  of  an  organization  should  be  just  sufficient, 
and  no  more,  for  its  needs.  Not  one  bit  of  this  capital,  in  any 
form  whatsoever,  should  get  into  the  hands  of  outsiders.  The 
ideal  situation  would  be  exactly  the  same  as  if  the  organization 
were  conducting  a  strictly  cash  business;  that  it  were  engaged 
in  only  one  line  of  business,  having  no  transactions  foreign  to 
this  line,  and  occupying  its  own  plant  entirely.  In  such  an 
ideal  organization  there  would  be  no  income  other  than  that  from 
operations.  That  the  ideal  does  not  exist  is  shown  by  the  fact 
that  at  times  capital  of  the  organization  which  is  not  required 
for  its  own  business  is  invested  in  stocks  and  bonds  of  other 
companies;  that  it  is  sometimes  permitted  to  get  into  the  hands 
of  outsiders,  through  extensions  of  credit,  thus  giving  rise  to 
accounts  and  notes  receivable;  that  a  portion  of  it  is  always 
deposited  in  the  bank.  It  also  happens  frequently  when  goods 
are  purchased,  for  example,  at  sixty  days,  that  there  is  a  discount 
offered  by  the  vendor  for  the  payment  of  cash  in  less  than  sixty 
days.  Thus,  theoretically,  a  part  of  the  capital  is  loaned  to  the 
vendor. 

The  above  transactions  give  rise  to  income  from  sources  other 
than  sales  (or  primary  income.)  This  income  is  called  secondary 
income,  because  of  the  fact  that  the  concern  in  question  is  not 
in  the  business  of  loaning  capital,  but  rather  in  the  business  of 

i8i 


Principles  of  Accounting 

manufacturing  and  selling  goods.  The  principal  object  of  the 
business  is  the  manufacture  and  sale  of  goods.  Therefore,  the 
primary  income  of  the  organization  must  be  from  the  same 
source.  Incident  to  the  manufacture  and  sale  of  goods  there 
are  these  transactions  of  capital,  and  from  them  income  is  derived. 
While  it  is  income,  it  is  secondary  to  the  principal  object  from 
which  income  is  sought.  Such  income  exists  in  the  form  of 
interest  on  bonds,  dividends  on  stock,  interest  on  bonds  and  mort- 
gages receivable,  interest  on  accounts  receivable,  interest  on  notes 
receivable,  interest  on  bank  balances  and  cash  discounts  on  pur- 
chases. There  is  also  included  in  this  group  royalties  receivable, 
commissions  receivable,  considerations  for  endorsing  notes,  accu- 
mulation of  discount  on  bonds,  and  rent.  With  regard  to  the 
last-mentioned  item,  it  should  be  borne  in  mind  that  the  rent 
is  not  that  received  through  sub-letting  a  portion  of  premises  for 
which  rent  is  paid.  It  represents,  rather,  rent  received  from 
property  not  used  in  the  operation  of  the  business.  Royalties 
and  commissions  are  included  in  this  group  not  because  they  are 
outside  operations,  but  operations  which  are  not  related  to  the 
primary  purpose  of  the  organization. 

The  point  to  be  kept  in  mind  with  regard  to  the  interest  items 
is  that  they  should  be  accrued  at  the  end  of  the  accounting  period. 
As  a  matter  of  convenience,  and  in  order  to  distinguish  between 
an  asset  and  a  liability,  many  accountants  have  adopted  a  tech- 
nical terminology  which  indicates  the  distinction.  This  scheme 
contemplates  referring  to  the  asset  as  accrued  interest,  while 
the  liability  is  called  interest  accrued.  There  would  be  no  par- 
ticular reason  for  calling  the  asset  accrued  interest,  rather  than 
interest  accrued,  if  every  one  were  to  use  the  same  terms  in 
describing  the  asset ;  but  where  some  use  the  term  interest  accrued 
for  the  asset  and  interest  accrued  for  the  liability,  in  connection 
with  interest  expense,  it  is  most  confusing.  It  is,  therefore, 
an  attempt  to  prescribe  a  working  nomenclature,  comprehensive, 
and  understood  by  every  one,  that  has  led  accountants  to  use 
certain  expressions,  such  as  the  one  above  described,  to  mean 
certain  things. 

Dividends  on  stocks  owned  may  not  be  accrued  at  the  end  of 
the  accounting  period.  A  dividend,  unlike  interest,  is  instan- 
taneous. It  comes  into  being  with  the  declaration  of  directors. 
At  the  end  of  a  given  period  the  net  profits  may  be  ample  to  allow 

182 


The  Secondary-Income  Group 

a  return  of  fifty  per  cent,  on  the  investment.  Stockholders  in 
the  corporation  are,  however,  just  as  far  away  from  a  return  on 
their  investment  as  if  they  held  no  stock.  They  have  no  right 
whatever  to  consider  that  their  investment  has  earned  a  return. 
The  situation  is  quite  changed,  however,  when  the  directors 
declare  a  dividend.  The  declaration  of  a  dividend  by  the  directors 
gives  to  the  stockholders  a  right  against  the  company  which  they 
may  enforce.  The  enforceable  right  thus  gives  rise  to  income. 
When  a  dividend  on  stock  has  been  declared  the  holder  of  the 
stock  is  entirely  justified  in  taking  the  dividend  into  his  income, 
even  though  not  yet  collected.  If  the  dividend  has  not  been 
declared  there  is  no  warrant  whatsoever  for  so  doing.  Thus 
it  may  be  said,  interest  may  be  accrued  always,  but  dividends 
never. 

It  is  possible  that  some  question  may  arise  with  regard  to 
cash  discounts  on  purchases.  Not  every  one  treats  cash  dis- 
counts on  purchases  as  other  income.  By  many  accountants  they 
are  treated  as  deductions  from  gross  purchases,  the  same  as 
trade  discounts.  By  some  accountants,  cognizance  is  taken  of 
cash  discounts  on  purchases  applying  to  invoices  which  will  be 
paid  during  the  first  few  days  of  the  next  succeeding  period. 
In  other  words,  if  it  is  the  practice  of  the  purchaser  to  pay  cash 
within  ten  days  for  all  goods  purchased,  the  accountant  will, 
at  the  end  of  a  given  period,  and  supposing  that  there  are  invoices 
to  the  extent  of  $30,000,  subject  to  discount  at  2  per  cent, 
charge  accounts  payable  and  credit  cash  discounts  on  purchases 
in  the  amount  of  $600.  This  procedure  is  entirely  correct  from 
the  point  of  view  which  this  accountant  takes.  It  is  not  correct 
from  the  point  of  view  of  the  accountant  who  follows  what 
may  be  called  the  more  advanced  lines  of  thought,  namely: 
those  which  consider  capital  as  the  medium  for  the  transaction 
of  business,  and  recognize  the  income  and  the  expense  attending 
such  capital.  If  discount  is  considered  in  the  light  of  interest, 
then  it  will  be  seen  that  the  payment  of  a  purchase  invoice  before 
it  is  due  gives  rise  to  interest  for  the  use  of  money  advanced 
to  the  vendor  before  he  was  entitled  to  receive  it.  It  is,  there- 
fore, apparent  that  the  question  of  interest  may  not  arise  until 
such  time  as  the  payment  has  been  made.  It  is  not  necessary, 
as  a  consequence  of  this  theory,  to  provide  at  the  time  of  closing 

183 


Principles  of  Accounting 

the  book  for  discounts  on  invoices  which  -  will  be  paid  in  the 
early  part  of  the  next  period. 

Another  item  which  sometimes  appears  in  this  group  is  con- 
sideration for  endorsing  notes.  This  is,  perhaps,  a  theoretical 
item  rather  than  otherwise.  The  author  has  not  in  his  experience 
encountered  an  example  of  this  kind,  although  such  instances 
are  said  to  have  existed.  The  income  represents,  practically, 
a  fee  received  for  the  guaranteeing  of  the  notes  of  others.  It 
is,  perhaps,  questionable,  where  an  item  of  this  kind  occurs  so 
infrequently,  whether  it  ought  not  rather  to  be  a  credit  to  profit 
and  loss  than  a  credit  to  income.  Income  is  intended  to  represent 
something  which  recurs ;  profit-and-loss  credits  comprise  unusual 
and  infrequent  items. 

Another  item  in  this  group  to  which  very  little  attention  is 
paid  is  the  income  corresponding  to  the  accumulation  of  a  bond 
purchased  below  par.  According  to  the  most  modern  and  scien- 
tific theory,  a  bond  the  interest  on  which  is  6  per  cent,  purchased 
below  par  will  yield  more  than  6  per  cent,  on  the  investment. 
This  is  due  to  the  fact  that  the  maker  of  the  bond  will  pay 
not  only  6  per  cent,  on  the  par  principal  during  the  life  of  the 
bond,  but  will  pay  the  par  principal  at  maturity.  For  example, 
a  $i,ooo  bond,  purchased  at  95,  would  cost  $950.  The  bond,  at 
maturity,  would  be  redeemed  at  $1,000.  The  investor,  whose 
investment  consists  of  $950,  will  receive  6  per  cent,  on  the 
par  of  the  bond,  but  more  than  6  per  cent,  on  his  investment 
of  $950.  It  is  true,  of  course,  that  each  year  he  will  receive 
m  cash  $60.  At  the  maturity  of  the  bond  he  will  receive  not 
only  his  investment  of  $950,  but,  in  addition,  $50  more,  repre- 
senting the  difference  between  his  investment  and  par.  This 
amount,  while  received  in  a  lump  sum,  has,  in  reality,  been 
earned  over  the  period  during  which  he  has  held  the  bond,  and 
it  is  quite  unfair  to  allow  the  profits  of  the  year  in  which  the  bond 
matures  to  benefit  by  the  entire  amount.  What  should  have 
been  done  was  to  spread  the  $50  in  question  over  the  number 
of  years  which  the  investor  held  the  bond.  It  is,  therefore, 
apparent  that  the  return  on  his  investment  would  have  been 
greater  than  6  per  cent.,  possibly  6^.  This  is  called  the  effective 
rate  of  interest,  as  compared  with  6  per  cent.,  the  nominal  in 
this  case.  The  excess  of  yield  over  the  nominal  will  depend 
upon  several  things,  namely:  the  purchase  price  of  the  bond, 

184 


The  Secondary-Income  Group 

the  nominal  rate  of  interest,  the  interest  periods,  and  the  length 
of  time  which  the  bond  has  to  run.  What  happens  is  that  the 
interest  earned  on  bonds  will  be  credited  not  only  with  6  per 
cent,  which  is  received  in  cash  but  >^  per  cent,  which  is  being 
periodically  added  to  the  face  of  the  investment.  Supposing, 
for  example,  that  on  an  investment  of  $950  in  a  certain  bond 
the  yield  was  6>^  per  cent.,  the  earning  then  for  the  year  would 
be  $61.75.  At  the  time  of  closing  the  books  the  following  entry 
would  be  made: 


Accrued  interest  on  bonds $60.00 

Bonds 1.75 

To  Interest  on  bonds $61.75 

Upon  receipt  of  the  interest  the  following  entry : 

Cash $60.00 

To  Accrued  interest  on  bonds $60.00 

It  will  be  seen  that  the  bond  investment  would  now  be  carried 
on  the  books  at  $951.75.  The  value  of  this  investment  would 
increase  from  time  to  time  in  accordance  with  the  amount  of  the 
excess  income  taken  into  the  interest  account,  and  would  con- 
tinue to  increase  periodically  until  at  the  time  of  maturity  it 
would  amount  to  $1,000.  An  entry  would  then  be  made  convert- 
ing the  bond  at  $1,000  into  cash.  The  process  of  increasing  the 
value  of  the  bond  has  sometimes  been  called  amortization.  It 
is  not  amortization,  but  the  reverse  of  same.  It  is  properly 
called  accumulation,  the  accumulation  consisting  of  the  increase 
in  the  investment  until,  at  the  time  of  the  maturity  of  the  bond, 
it  reaches  par.  The  term  amortization  presumably  came  into 
use  because  it  was  considered  that  the  discount  representing  the 
difference  between  the  investment  price  and  par  was  being  amor- 
tized, or  reduced. 

This  group  corresponds  to  the  fourth  section  of  the  state- 
ment of  income  and  profit  and  loss,  which  appears  as  follows. 
The  items  representing  the  accounts  involved  are  closed  out 
into  the  group  account  income  from  other  sources : 

185 


Principles  of  Accounting 

Interest  on  bonds  owned $400.00 

Dividends  on  stocks  owned $250.00 

Interest  on  bonds  and  mortgages  (receivable) . .  300.00 

Cash  discounts  on  purchases 750.00 

Interest  on  bank  balances 50.00 

Interest  on  accounts   (receivable) 75-00 

Interest  on  notes  (receivable) 375 -oo 

Rent  (receivable) 145.00 

Royalties  (receivable) 300.00 

Commissions  (receivable) 250.00 

Accumulation  on  bonds 5.OO 

Total  income  from  other  sources $2,900.00 


186 


CHAPTER   XXX 

DEDUCTIONS  FROM   INCOME  GROUP 

In  discussing  the  items  under  this  group  it  is  again  necessary 
to  consider  capital  as  the  medium  whereby  the  business  of  the 
organization  is  transacted.  In  theory,  the  group  contains  only 
items  which  are  in  the  nature  of  expenses  of  capital.  Capital 
expenses  should  be  distinguished  from  capital  expenditures.  It 
should  be  thoroughly  understood  that  what  is  not  meant  is  an 
expenditure  of  the  funds  of  the  organization,  which  is  capitalized, 
or  set  up  as  an  asset.  It  distinguishes  the  expenses  in  connec- 
tion with  capital  from  the  expenses  in  connection  with  operations. 
While  capital  is  necessarily  involved,  and  is  employed  in  the 
operations,  the  expenses  of  obtaining,  using  or  protecting  capital 
are  set  up  separately,  in  order  to  show  what  the  income  from 
operations  would  be  if  there  were  no  expenses  in  connection 
with  capital. 

Aside  from  being  based  on  sound,  economic  principles,  this 
theory  requires  a  classification  which  greatly  facilitates  the  com- 
parison of  different  organizations.  Only  like  quantities  may 
be  compared.  In  the  same  way,  only  like  organizations  may 
be  compared.  It  is  in  the  matter  of  items  comprising  this  group 
in  which  there  is  greatest  conflict  when  comparison  is  attempted. 

The  principal  items  in  the  group  are  interest  on  bonds  and 
mortgages  payable,  interest  on  accounts  payable,  interest  on  notes 
and  loans  payable,  cash  discounts  on  sales,  rent  (payable),  insur- 
ance expense,  taxes,  interest  on  capital  and  royalties  (payable). 
Of  these,  the  interest  items  are  probably  easiest  to  compre- 
hend, as  coinciding  with  the  theory  advanced.  Interest  on  bonds 
and  mortgages,  accounts  or  notes  is  paid  because  of  the  fact 
that  the  organization  has  not  sufficient  capital  of  its  own  with 
which  to  transact  business.  If  the  owned  capital  were  suffi- 
ciently large  there  would  be  no  occasion  for  borrowing  on  any 
of  the  instruments  just  mentioned.  It  is  because  of  the  fact 
that  interest  is  an  expense  of  obtaining  capital  that  it  is  classified 
in  this  group. 

Cash  discount  is  not  so  easily  reconciled,  because  of  the 
custom  which  is,  at  the  present  time,  perhaps,  rather  general,  of 

187 


Principles  of  Accounting 

considering  cash  discount  as  a  deduction  from  sales,  the  same 
as  trade  discount.  In  order  to  get  the  proper  conception  of 
the  theory,  as  appHed  to  cash  discount,  it  is  necessary  to  con- 
sider it  practically  the  same  as  interest.  A  merchant  who  buys 
an  invoice  of  goods  makes  a  contract.  The  contract  of  purchase 
and  sale  arises  when  certain  specific  goods  ready  for  delivery 
have  been  offered  and  accepted.  Under  the  terms  of  the  con- 
tract, delivery  may  be  made  immediately;  but  the  purchaser,  if 
the  question  of  cash  discount  is  to  enter  into  the  question,  will 
probably  be  permitted  thirty,  sixty,  or  possibly  ninety  days,  to 
make  settlement.  If  this  question  of  credit  were  not  involved 
cash  discount  would  not  enter  into  the  problem.  It  is  because 
of  the  fact  that  a  contract  has  been  made,  and  the  payment  of 
the  purchase  price  stipulated  at  thirty  days,  or  longer,  that  the 
vendor  offers  a  cash  discount  as  an  incentive  to  the  purchaser 
to  make  an  earlier  settlement.  In  other  words,  the  vendor  offers 
to  pay  interest  for  the  use  of  the  money  if  he  may  obtain  it 
before  it  is  due  under  the  terms  of  the  contract.  The  vendor 
is,  therefore,  in  the  position  of  having  borrowed  money  from 
the  purchaser,  for  which  he  virtually  pays  interest.  Thus  it 
becomes  perfectly  logical  to  include  cash  discount  on  sales  as  a 
deduction  from  income,  on  the  theory  that  it  is  an  expense  of 
obtaining  capital.  It  need  scarcely  be  pointed  out  that  as  a 
matter  of  financial  policy  the  offering  of  a  cash  discount  is  good 
finance.  To  the  concern  engaged  in  a  business  in  which  the 
profits  are  large  the  money  is  worth  very  much  more  than  the 
small  amount  of  cash  discount  paid  for  its  use. 

There  are  two  very  good  reasons  for  treating  rent  as  a 
deduction  from  income.  The  first  one  is  that  rent  is  considered 
by  the  economist  not  an  expense  of  the  business  but  a  share 
of  the  profits,  which  the  tenant  turns  over  to  the  landlord 
for  the  use  of  the  premises.  The  second  is  that  a  concern  paying 
rent  does  so  either  because  of  the  fact  that  it  does  not  own  its 
own  property,  on  account  of  lack  of  capital,  or  because  it  is 
inexpedient  to  do  so.  In  either  case,  rent  seems  to  be  analogous 
with  interest,  since  it  is  paid  for  the  use  of  capital  in  the  form 
of  property.  As  an  expense,  therefore,  of  capital  it  is  properly 
treated  as  a  deduction  from  income.  The  question  is  often  raised 
as  to  the  propriety  of  treating  the  rent  of  the  general  office  of 
an   organization  as   deduction   from   income.     The   question   is 

i88 


Deductions  from  Income  Group 

often  asked,  "Would  you  consider  the  rent  of  an  office  in  New 
York  City  in  this  class  ?"  The  question  is  probably  prompted  by 
men  who  have  in  mind  the  thought  that  a  great  number  of  indus- 
trial and  mercantile  organizations  throughout  the  country  main- 
tain general  offices  in  New  York  City.  It  seems  strange  to  them 
that  such  concerns  should  arbitrarily  be  placed  in  the  position 
of  borrowing  capital.  The  tendency  is  to  consider  rent  paid 
for  such  offices  as  an  administrative  expense.  The  disposition  is 
to  connect  the  expense  specifically  with  the  department  of  the 
organization  for  which  the  expense  was  incurred  rather  than 
as  an  expense  of  capital. 

Illogical  as  it  may  seem  to  many,  there  is  no  exception,  so 
far  as  the  author  is  aware,  to  the  treatment  of  rent  as  a  deduc- 
tion from  income,  under  the  theory  that  the  concern  is  occupying 
borrowed  property  or  capital.  True,  a  large  industrial  organiza- 
tion m.ay  not  rent  an  office  in  New  York  City  because  of  the 
fact  that  it  has  not  sufficient  capital  to  own  its  own  building. 
The  point  is  that  it  does  not  find  it  expedient  to  invest  the  large 
sum  of  money  necessary  to  purchase  or  construct  a  building  of 
its  own  where  it  requires  general  offices.  It  is  cheaper  to  rent 
than  to  own.  This  view  does  not  alter  the  fact  that  when  it 
does  rent  it  occupies  the  property  of  another  rather  than  tie 
up  its  own  capital  in  the  investment,  and,  therefore,  does  pay  a 
rent  which  is  analogous  to  interest  for  the  use  of  capital. 

Insurance  is  a  premium  paid  for  the  protection  of  property. 
It  is  a  risk  assumed  by  the  company  in  behalf  of  the  assured 
against  through  loss  by  fire,  theft,  accident,  or  loss  from  acts 
of  nature.  It  is  money  paid  for  the  protection  of  capital.  It 
is,  therefore,  an  expense  of  capital,  and  as  such  is  properly  con- 
sidered as  a  deduction  from  income.  Here  again  many  find  it 
difficult  to  disassociate  insurance  from  the  particular  property 
which  is  insured.  Perhaps  the  average  student  of  the  subject  will 
insist  that  insurance  on  materials  and  supplies  in  stores  is  not 
properly  treated  otherwise  than  as  an  expense  of  the  operating  de- 
partment. The  question  often  asked  is,  "How  can  you  consider 
insurance  paid  for  the  protection  of  your  factory  property  as  an 
expense  of  capital  ?"  The  answer  is  that  capital  is  invested  in  the 
factory  property,  and  just  as  interest  paid  for  the  use  of  money 
so  employed  is  considered  as  an  expense  of  capital,  so  insurance 
paid  for  the  protection  of  this  capital  is  a  similar  expense  of 

189 


Principles  of  Accounting 

capital.  More  than  one  student  seeking  the  light,  or  perhaps 
attempting  to  find  a  flaw  in  the  reasoning  advanced  in  accord- 
ance with  this  theory,  has  asked  the  question,  "Why  not  charge 
the  wages  of  the  watchman  at  the  factory  to  insurance,  or  treat 
it  as  a  deduction  from  income  ?"  A  specific  answer  to  the  question 
might  consist  in  saying  that  no  money  is  invested  in  the  watch- 
man, and  therefore  there  is  no  expense  which  can  be  traced 
directly  to  capital.  This  line  of  reasoning,  though  somewhat 
simple,  will,  it  is  believed,  always  produce  the  correct  result. 

Taxes  are  included  in  this  group  for  the  reason  that  they 
are  likewise  paid  for  the  protection  of  capital.  The  State  under- 
takes to  exercise  the  police  power.  It  protects  the  property  of 
the  citizen  as  well  as  the  property  of  the  business  man.  For 
this  protection  it  exacts  a  tax.  The  business  organization  with 
capital  invested  is,  therefore,  protected.  The  taxes  are  an  expense 
of  such  protection.  The  questions  raised  in  connection  with  con- 
sidering taxes  as  deduction  from  income  are  generally  irrespective 
of  organization  taxes  and  the  tax  on  net  income.  It  is  possible, 
without  a  great  deal  of  difficult  reasoning,  to  place  these  items 
in  the  same  class.  These  taxes  apply  only  to  corporations. 
Obviously,  a  corporation  may  not  own  capital  until  it  has  been 
organized.  If  the  tax  is  paid  for  organization  it  gives  to  the 
corporation  the  right  to  own  capital.  The  fee  for  this  right  is 
in  connection  with  capital,  and,  therefore,  becomes  an  expense 
of  capital.  The  federal  corporation  tax  law  imposes  on  corpo- 
rations, joint  stock  companies,  or  associations  organized  for  oper- 
ation and  having  a  capital  stock  represented  by  shares,  a  special 
excise  tax  with  respect  to  the  carrying  on  of  or  doing  busi- 
ness. It  further  provides  for  a  tax  on  the  net  income  and  the 
profits  in  excess  of  certain  fixed  rates.  Here  again  it  will 
be  seen  that  the  theory  is  logical,  since,  in  the  first  place,  the 
tax  is  imposed  by  the  government  for  the  privilege  of  doing 
business,  in  which  privilege  the  corporation  is  protected;  and 
in  the  second  place,  the  net  income  is  shared  with  the  government 
for  such  privilege.  It  cannot  be  argued,  it  seems,  that  this  tax 
is  a  part  of  the  cost  of  the  goods  sold,  the  expense  of  selling 
them,  or  the  expense  of  administering  the  business,  but  rather 
a  specific  deduction  from  the  income.  The  difficulty  involved 
in  making  this  point  clear  has  more  than  once  arisen  when  the 
question  has  been  asked.  Shall  such  taxes  be  considered  before 

190 


Deductions  from  Income  Group 

the  net  income  is  arrived  at?  Clearly  this  is  not  possible  under 
the  law,  any  more  than  it  is  a  pertinent  question.  In  making 
up  its  return  to  the  government  the  corporation  will  determine 
its  net  income.  The  government  will  then  compute  the  tax. 
This  report,  however,  is  something  quite  different  from  the  com- 
pany's statement  of  income  and  profit  and  loss. 

On  account  of  the  importance  of  interest,  insurance  and 
taxes,  apart  from  the  role  which  they  play  in  disclosing  true 
economic  or  operating  results,  they  will  be  made  the  subject, 
as  in  the  case  of  depreciation,  of  separate  chapters  which  follow. 

In  preparing  the  statement  of  income  and  profit  and  loss 
the  items  in  this  group,  as  appearing  below,  will  constitute  the 
sixth  section,  and  in  closing  the  books  will  be  closed  into  the 
group  account — deductions  from  income: 

Interest  on  bond  and  mortgage  payable $2,000.00 

Interest  on  accounts  payable 200.00 

Interest  on  notes  and  loans  payable 500.00 

Cash  discount  on  sales 300.00 

Rent  (payable) 400.00 

Insurance 100.00 

Taxes 200.00 

Royalties  (payable) 300.00 

Total  deductions  from  income $4,000.00 


.191 


CHAPTER   XXXI 

DEPRECIATION 

Depreciation  may  be  defined  as  the  decrease  in  the  value 
of  an  asset,  due  to  deterioration  through  lapse  of  time,  wear  and 
tear,  or  obsolescence.  It  is,  under  all  circumstances,  an  estimate. 
It  has  been  very  strikingly  remarked  that  man  and  nature  are 
constantly  at  work  seeking  to  destroy  all  physical  property.  All 
physical  assets  are  constantly  undergoing  deterioration  as  time 
passes.  With  some  assets  it  is  more  marked  than  with  others. 
It  is  rather  difficult  to  recognize  deterioration  in  the  case  of  a 
desk.  It  is  easier  to  recognize  it  in  the  case  of  an  iron  pipe 
which  is  exposed  to  the  weather.  It  is,  nevertheless,  true  that, 
although  unobserved,  deterioration  is  constantly  taking  place. 
On  the  other  hand,  man,  through  the  use  of  physical  assets  caus- 
ing what  is  known  as  wear  and  tear,  is  constantly  decreasing 
the  value  of  said  physical  assets.  In  a  similar  way  he  seeks, 
through  invention,  to  find  newer  and  better  machines  and  articles 
of  equipment  for  the  manufacture  of  goods  and  transaction  of 
business.  The  business  man  naturally  turns  to  that  which  is 
newest  and  best,  laying  aside,  perhaps,  that  which  has  served 
him  faithfully,  because  of  the  saving  either  in  money  or  energy 
through  the  use  of  the  new  invention.  It  is  said  of  Mr.  Andrew 
Carnegie  that  he  owes  his  success  in  a  very  large  measure  to 
his  ability  to  recognize  new  machines  and  his  courage  in  casting 
aside  machines  which  had  thus  become  obsolete.  The  dictionary 
defines  obsolete  very  simply  and  specifically  as  something  which 
has  "gone  out  of  use."    i^'<^  "  ^0^  ^,<v>v>fv--xi4A^  J^>-u^t^"^ 

The  recognition  of  the  existence  of  depreciation  may  be  re- 
garded as  a  somewhat  recent  one.  Until  a  comparatively  short 
time  ago  accounting  practice  did  not  take  into  consideration  the 
element  of  depreciation.  That  it  is  an  important  element,  and 
cannot  escape  recognition,  is  borne  out  by  the  many  litigations  that 
have  arisen  in  the  last  quarter  of  a  century.  In  the  case  of 
Conville  v.  Shook,  et  al.  (24  N.  Y.  Supp.  547,  1893),  the  action 
was  to  recover  the  sum  of  $6,779.40  by  the  plaintiff  from  the  de- 
fendant for  the  former's  share  of  the  profits  of  the  business  for  a 
given  year.     The  defendant  claimed  that  the  plaintifiF's  share  of 

192 


Depreciation 

the  profits  during  the  year  in  question  was  greatly  less  than  the 
sum  claimed  by  said  plaintiff.  Testimony  was  introduced  by  an 
accountant  to  the  effect  that  numerous  items  were  improperly 
entered  on  the  books,  the  sixth  one  of  which  was  depreciation  of 
the  original  plant.  It  appears  to  have  been  the  practice  to  provide 
for  depreciation  at  the  rate  of  lo  per  cent,  per  annum.  In  that 
way  assets  originally  costing  $45,000  had  been  reduced  at  the  time 
of  accounting  to  $29,309.45.  It  was  held  by  the  court  that  there 
was  no  reason  why  the  original  plant  should  have  been  carried  on 
the  books  for  ten  years  at  the  original  cost.  The  charge  for  de- 
preciation was  sustained. 

In  the  case  of  Emery  v.  Wilson  (79  N.  Y.  78),  Emery, 
Wilson  and  a  third  party  were  copartners,  sharing  in  the  profits 
one-tenth,  four-tenths  and  five-tenths,  respectively.  Upon  the 
death  of  one  of  the  partners,  namely,  the  third  party  mentioned, 
an  action  was  brought  for  the  accounting  and  settlement  of  the 
copartnership  affairs.  A  question  as  to  whether  it  was  proper 
to  allow  for  depreciation  in  the  value  of  the  property  in  ascer- 
taining the  profits  arose.  The  referee  apparently  refused  to  permit 
an  allowance  for  depreciation,  and  was  sustained  by  the  court. 

In  the  case  of  Tutt  v.  Sand  (56  Ga.  339),  it  appears  that 
Tutt  and  Sand  entered  into  a  copartnership  whereby  Sand,  the 
defendant,  was  to  furnish  the  stock  of  goods  then  on  hand,  and 
the  plaintiff,  Tutt,  was  to  render  his  skill,  services,  etc.  The 
former  was  to  have  three-fourths  of  the  profits,  the  latter  one- 
fourth.  The  partnership  was  dissolved,  and  the  plaintiff  brought 
an  action  for  $10,000  as  his  share  of  the  profits  which  had  been 
made.  The  defendant  sought  to  set  off  against  this  amount 
various  claims  and  expenses,  among  which  was  an  item  of 
$4,098.11,  covering  a  depreciation  of  10  per  cent,  on  merchan- 
dise. In  this  case  it  appears  that  the  item  of  depreciation  was 
not  allowed  to  stand  as  an  individual  matter  between  the  part- 
ners, or,  in  other  words,  as  a  set  off,  but  was  properly  included 
as  an  expense  of  the  business,  and  borne  jointly  by  the  two 
partners. 

In  the  case  of  the  San  Diego  Water  Company  v.  City  of 
San  Diego,  the  plaintiff  was  a  corporation  engaged  in  the  busi- 
ness of  supplying  water  to  the  city  of  San  Diego  and  its  inhabi- 
tants. The  Common  Council  of  the  city  passed  an  ordinance 
fixing  the  water  rate  for  the  year.    The  plaintiff  sought  to  annul 

193 


Principles  of  Accounting 

the  ordinance  on  various  grounds,  one  being  that  the  rate  so 
fixed  would  be  insufficient  to  pay  its  operating  expenses  and 
fixed  charges,  and,  therefore,  afford  no  reward  to  the  plaintiff 
for  furnishing  water,  which  would  be  depriving  the  plaintiff  of 
its  property  without  due  process  of  law  and  without  compensa- 
tion. The  water  company  appears  to  have  sought  to  include 
as  an  item,  in  making  up  the  cost  on  which  the  rate  was  based, 
a  sinking  fund  provision  for  depreciation.  The  court  held  that 
no  percentage  upon  the  investment  could  properly  be  charged 
as  a  sinking  fund,  to  be  added  to  the  operating  expenses,  as  a 
general  provision  against  depreciation  of  the  plant  through  use. 

In  a  similar  case,  namely,  the  Redlands  Water  Company 
v.  the  City  of  Redlands  (121  Cal.  312),  the  city  likewise  adopted 
an  ordinance  fixing  the  rate.  The  water  company  brought  an 
action  to  annul  the  ordinance  on  the  ground  that  the  rate  would 
be  insufficient  to  enable  it  to  pay  the  interest  on  its  indebtedness, 
its  operation  expenses  and  taxes,  and  for  keeping  its  plant  in 
repair.  It  was  held  by  the  court  that  the  water  company  was 
not  entitled  to  have  the  rate  so  fixed  as  to  enable  it  to  set  apart 
a  certain  amount  each  year  as  a  sinking  fund  for  the  depreciation 
of  its  plant. 

In  the  case  of  Whittaker  v.  Amwell  National  Bank  (52  N.  J. 
Eq.  400,  1894),  one  of  the  questions  at  issue  was  whether  or 
not  dividends  declared  and  paid  by  the  Star  Rubber  Company, 
one  of  the  defendants  in  this  suit,  were  paid  out  of  the  surplus 
or  net  earnings  of  the  company.  It  was  held,  among  other  things, 
that  this  could  only  obtain  by  taking  into  account  the  cost  of 
repairs  and  a  reasonable  allowance  for  depreciation  for  wear 
and  tear.  The  court  said:  "It  cannot  be  successfully  contended 
that  all  such  machinery  is  not  subject  to  depreciation  from  wear 
and  tear  or  actual  use.  That  all  machinery  does  not  suffer  alike 
is  equally  plain.  The  testimony  in  this  case  leads  me  to  the 
conclusion  that  the  depreciation  was  at  least  2  per  cent,  a  year." 

In  one  of  the  most  recent  cases,  namely,  Cumberland  Tele- 
phone and  Telegraph  Co.  v.  City  of  Louisville  (187  Fed.  Rep. 
637,  decided  April  25,  191 1),  the  question  of  depreciation  arose 
in  a  suit  brought  by  the  telephone  company  to  enjoin  the  enforce- 
ment of  an  ordinance  as  confiscatory  and  unconstitutional.  In 
this  case  the  court  took  cognizance  of  depreciation,  and  said: 
"We  define  depreciation  to  be  the  loss  in  value  of  some  destruct- 

194 


Depreciation 

ible  property  over  and  above  current  repairs."  There  was  in- 
volved in  this  suit  the  question  of  what  proportion  of  the  com- 
pany's annual  earnings  shall  be  set  aside  for  making  good  the 
depreciation  and  replacing  the  parts  of  the  property  when  they 
come  to  the  end  of  their  life.  This  question  was  one  altogether 
apart  from  and  beyond  current  repairs.  On  this  question  the 
court  ruled  as  follows:  "A  reasonable  amount  to  be  set  apart 
in  this  climate  for  making  good  depreciation  is  7  per  cent,  of 
the  value  of  the  fixed  plant,  exclusive  of  real  estate,  working 
capital  and  supplies  in  hand.  The  testimony  clearly  leads  to  the 
conclusion  that  the  average  life  of  the  combined  elements  which 
make  up  the  plant  is  about  fourteen  years,  and  we  shall  proceed 
upon  that  theory.  In  estimating  depreciation,  we  will  reckon  it 
at  7  per  cent,  of  $1,575,000,  the  value  of  the  destructible  parts 
of  the  plant.  Of  course,  our  estimate  cannot  be  based  upon  the 
proposition  that  the  per  centum  set  apart  to  cover  depreciation 
would  be  deposited  in  banks  or  loaned  out  from  year  to  year, 
so  as  to  accumulate,  and  be,  at  the  end  of  fourteen  years,  used 
to  construct  an  entirely  new  plant.  In  such  a  case  the  public 
would  not  only  have  a  service  that  would  grow  worse  when  its 
operation  ceased  altogether,  but  it  would  thereafter  get  no  service 
at  all  until  a  new  plant,  replacing  the  old,  could  be  completed 
and  put  into  operation." 

It  will  be  seen  from  the  last-mentioned  case  that  it  is  one  of 
the  latest  and  most  modern  rulings  on  the  subject.  It  will  also 
be  noted,  in  glancing  over  previous  cases,  that  while  there  have 
been  some  decisions  which  refused  to  recognize  the  element  of 
depreciation  the  tendency  at  the  present  time  is  toward  a  general 
recognition.  The  Interstate  Commerce  Commission  and  the  vari- 
ous Public  Service  Commissions  have  done  much  to  establish  this 
recognition. 

Regardless  of  legal  decisions,  it  must  be  borne  in  mind  that 
depreciation  is  a  very  important  item,  since  no  matter  what  the 
type  of  organization  may  be,  or  what  the  nature  of  the  business, 
the  net  profits  will  be  affected  in  accordance  with  whether  or  not 
depreciation  is  allowed  to  enter  into  the  accounts.  It  seems  that 
it  must  be  considered  as  conclusive  that  physical  property  does 
depreciate  in  value,  and  that  if  such  depreciation  takes  place  it  is 
a  proper  charge  against  the  expense  of  the  period.  If  this  is 
true,  and  depreciation  has  not  been  included  as  an  item  of  expense, 

195 


Principles  of  Accounting 

then  the  net  profits  are  incorrectly  stated.  Hence  the  importance 
in  all  contracts  of  copartnership,  and  similar  contracts,  of  recog- 
nizing and  providing  for  depreciation  in  the  stating  of  the 
accounts.  To  illustrate  this  point  concretely,  suppose  that  a  cer- 
tain firm  should  acquire  a  parcel  of  land,  including  a  building, 
at  a  cost  of  $25,000.  Assume,  if  you  like,  the  copartnership  to 
continue  for  thirty  years.  At  the  time  of  dissolution  assume  that 
in  the  distribution  of  the  assets  A  elects  to  take  the  property  at 
its  cost,  namely,  $25,000.  Assume  further  that  the  property  is 
so  situated  that  there  has  been  no  perceptible  appreciation  in 
the  value  of  the  land,  and  that  the  former  partner,  A,  now  attempts 
to  dispose  of  the  property,  and  is  suddenly  confronted  with  the 
fact  that  it  will  not  bring  more  than  $10,000.  The  injustice  and 
inequality  of  having  failed  to  provide  for  the  depreciation  of 
this  property  before  the  copartnership  accounts  were  stated,  and 
the  affairs  settled,  will  be  very  evident. 

Admitting  the  necessity  for  depreciation,  it  must  then  be 
observed  that  it  will  vary  in  different  localities  with  regard  to 
the  nature  of  the  assets,  the  use  to  which  they  are  put,  and  the 
kind  of  use  which  they  receive.  It  will  be  recalled  in  the  case 
of  Whittaker  v.  Amwell  National  Bank  the  court  was  led  to 
conclude  that  depreciation  was  at  least  2  per  cent,  a  year,  while 
in  the  case  of  Cumberland  Telephone  and  Telegraph  Company 
V.  City  of  Louisville  depreciation  was  allowed  at  the  rate  o' 
7  per  cent,  a  year.  The  question  may  be  asked.  Why  this  wide 
variation  in  rates?  While  the  cases  do  not  show  specifically  the 
kind  of  property  involved,  it  is  probable  that,  making  due  allow- 
ance for  failure  of  the  courts  to  employ  a  scientific  rate  estab- 
lished by  experience,  there  was  some  marked  difference  in  the 
nature  of  the  asset  or  the  use  to  which  it  was  put.  Obviously, 
the  rate  of  depreciation  upon  a  dwelling  which  receives  careful 
use  at  the  hands  of  its  occupants  will  not  be  as  high  as  that  for 
a  taxicab  which  is  being  constantly  driven  about  the  streets,  over 
rough  pavements,  at  a  high  speed.  As  a  matter  of  further  illus- 
ration,  a  case  of  boilers  may  be  mentioned.  In  the  southwestern 
part  of  the  United  States  especially,  where  the  water  contains  a 
great  amount  of  alkali,  the  boilers  will  scale  and  need  replace- 
ment at  least  five  times  as  often  as  in  the  northeastern  New 
England  States,  where  the  water  has  little  effect  upon  boilers. 
To  charge  the  same  rate  of  depreciation  in  both  places  would 

196 


Depreciation 

be  entirely  incorrect.  In  the  same  way,  buildings  containing 
heavy  machinery,  and  which  are  subject  to  constant  and  marked 
vibration,  will  depreciate  much  faster  than  buildings  wherein 
no  such  machinery  is  found. 

Experience  only  will  determine  the  proper  rate  of  deprecia- 
tion to  be  used  in  each  particular  case.  Appraisal  companies  have 
probably  the  best  detailed  information  on  this  subject  in  the 
country.  Since  this  information  constitutes  in  part  their  stock 
in  trade  they  are  loath  to  make  it  public.  That  the  variations 
in  rates  are  great  will  be  seen  in  consulting  tables  such  as  those 
compiled  by  Mr.  George  A.  Cravens  (published  in  The  Electrical 
Review,  April  23,  1910,  and  reproduced  in  Montgomery's  "Au- 
diting," page  325),  in  which  depreciation  of  boilers  is  seen  to 
fluctuate  from  33^  to  10  per  cent,  per  annum.  Mr.  H.  S.  Tiffany, 
in  his  book  called  "Digest  of  Depreciations,"  which  is  probably 
one  of  the  most  complete  tables  extant,  places  the  average  life 
of  a  boiler  at  ten  years,  and  therefore  computes  the  depreciation 
at  10  per  cent.  Mr.  Tiffany's  note  bearing  on  the  use  of  the 
property,  as  follows,  is  interesting:  "In  giving  the  percentages 
of  depreciation  on  engines  and  boilers  it  is  assumed  that  a  careful 
and  competent  engineer  is  employed,  and  that  they  are  well 
cared  for.  Where  this  is  not  the  case  the  per  cent,  is  largely 
increased,  and  many  cases  have  been  known  where  in  less  than 
five  years  they  have  been,  through  carelessness,  rendered  entirely 
useless,  and  consequently  worthless." 

While  attention  is  usually  given,  in  so  far  as  depreciation  is 
concerned,  to  buildings,  equipment,  etc.,  very  little  attention  is 
ever  given  to  the  depreciation  of  land.  It  is  usually  assumed 
that  land  does  not  depreciate.  This  is  probably  true  with  regard 
to  all  land  except  that  used  for  agricultural  purposes.  Mr.  R.  H. 
Montgomery,  in  his  book  on  "Auditing,"  calls  attention  to  the 
fact  that  "land  used  for  agricultural  purposes  may  depreciate 
through  use,  and  does  depreciate  unless  a  certain  rotation  of  crops 
is  followed,  or  unless  fertilizers  are  used.  The  latter  is  equivalent 
to  the  cost  of  maintenance  and  repairs  in  a  factory.  The  price 
of  flaxseed  has  increased  enormously  because  during  the  early 
years  of  farming  in  the  West  the  vitality  of  the  land  was  ex- 
hausted by  raising  a  crop  which  impoverished  the  soil  to  such 
an  extent  that  farmers  were  obliged  to  discontinue  the  raising 
of  flaxseed.     During  this  period,  when  this  crop  was  using  up 

197 


Principles  of  Accounting 

the  value  of  the  land,  the  farmers  should  have  set  up  a  reserve 
for  depreciation,  and  it  would  have  been  apparent  that  the  net 
price  realized  from  the  flax  crop  was  not  nearly  so  high  as  it 
seemed,  but  that  wheat,  while  bringing  in  less  per  acre,  would 
have  been  more  profitable.  Heretofore,  text-books  on  auditing 
have  stated,  without  qualification,  that  land  does  not  depreciate. 
If  it  is  a  fact  that  three-fourths  of  the  land  in  the  United  States 
is  depreciating  through  use,  these  statements  should  not  have 
been  allowed  to  go  unchallenged  so  long." 

Another  important  matter  to  be  kept  in  mind  in  connection 
with  depreciation  is  its  relation  to  repairs.  Most  authors  agree 
that  depreciation  is  something  quite  apart  from  repairs  and 
maintenance.  It  is  true  that  if  an  asset  is  repaired  and  maintained 
it  will  last  longer  than  if  such  is  not  the  case.  It  should  be  borne 
in  mind  that  in  estimating  the  life  of  a  given  asset  allowance 
must  be  made  for  a  reasonable  amount  of  maintenance  and 
repairs.  If  repairs  are  neglected  the  life  of  the  asset  will  be 
shortened.  If  the  asset  is  thoroughly  maintained  its  life  may 
be  lengthened.  The  point  which  the  author  is  especially  anxious 
to  bring  out  is  the  fact  that  rates  heretofore  and  hereafter  men- 
tioned exclude  any  provision  for  repairs  and  maintenance;  that 
the  depreciation  takes  place  quite  apart  from  the  charge  to 
expenses  which  is  made  for  repairs  and  maintenance. 

Before  proceeding  to  a  discussion  of  the  various  methods 
of  computing  depreciation  some  attention  should  be  given  to  the 
bases  on  which  it  is  computed,  namely,  the  cost  of  the  asset, 
its  estimated  Hfe,  and  the  residual  value.  Most  assets,  whatever 
their  life  may  be,  will  ultimately  have  a  scrap  or  residual  value. 
This  is,  of  course,  at  best  an  estimate,  the  same  as  the  life  of 
the  asset  is  an  estimate.  The  existence  of  the  residual  value 
should  be  recognized  and  an  attempt  made  to  fix  it  as  well  as 
possible.  If  the  residual  value  is  recognized,  it  is  apparent  that 
before  the  amount  which  is  to  be  charged  oflf  or  depreciated 
can  be  ascertained  the  residual  value  must  be  deducted  from 
the  original  cost.  The  result  then  is  the  amount  which  is  to  be 
spread  over  the  estimated  life  of  the  asset. 

With  regard  to  the  methods  employed  in  computing  the  annual 
rate  at  which  depreciation  may  be  charged  to  the  operating  ex- 
penses there  are  two  which  are  worthy  of  special  mention,  as 
being  entirely  practicable,  whereas  several  others  may  be  discussed 

198 


Depreciation 

merely  as  a  matter  of  interest.  Most  authors,  writers  and  authori- 
ties recognize  three  different  methods,  namely :  ( i )  the  fixed 
percentage  of  the  original  value,  or  the  flat  rate,  as  it  is  frequently 
called;  (2)  the  fixed  percentage  on  balances,  or  the  reducing 
scale  basis;  (3)  the  sinking  fund.  Some  authors  mention  an 
increasing  scale,  while  others  suggest  not  a  percentage  at  all, 
but  depreciation  determined  by  revaluation  at  inventory  periods. 
It  is  also  true  that  mining  companies  base  their  depreciation,  or, 
in  reality,  depletion,  on  tonnage,  charging  off  five  or  ten  cents, 
or  whatever  it  may  be,  per  ton,  in  accordance  with  the  number 
of  tons  extracted.  This  same  basis  might  also  be  used  in  the 
case  of  a  foundry  furnace,  the  lining  for  which  is  constantly  being 
exhausted,  and  is  wearing  out  in  direct  proportion  to  the  number 
of  tons  of  molten  metal  which  pass  through  it.  Of  the  various 
methods  mentioned,  the  fixed  percentage  is  probably  the  most  j 
practicable  and  easiest  of  application.  It  contemplates  dividing 
the  original  cost,  less  the  residual  value,  by  the  estimated  number 
of  years  of  life  and  charging  off  a  corresponding  percentage  each 
year.  In  this  way  the  depreciation  is  spread  equally  over  the 
life  of  the  asset.  The  reducing-scale  method  is  advocated  by 
adherents  who  claim  that  repairs  and  maintenance  are  heaviest 
during  the  latter  part  of  the  life.  They  contend,  therefore,  that 
in  order  to  secure  an  equitable  charge  against  the  profits  of  the 
respective  periods  a  larger  amount,  steadily  decreasing,  should 
be  charged  against  the  earlier  years  of  the  life,  whereas  a  smaller 
amount  should  be  charged  during  the  later  years,  when  the  main- 
tenance is  steadily  increasing.  It  must  be  conceded  that  there 
is  considerable  merit  in  this  contention,  and  it  is,  perhaps,  not 
any  more  difficult,  after  the  first  mathematical  calculation  has  , 
been  made,  than  the  first  method  suggested.  The  practical  objec-  ^ 
tion  to  it  is  that  the  ordinary  layman  is  not  sufficiently  familiar 
with  algebraic  formulas  to  determine  the  percentage.  The  fixed 
percentage  on  original  cost  is  the  layman's  way  of  computing 
depreciation. 

With  regard  to  the  sinking-fund  method,  it  is  probable  that 
this  is  the  most  scientific.  It  does  not  necessarily  follow  that 
because  the  sinking-fund  method  of  ascertaining  the  amount  is 
used  a  sinking  fund  must  actually  be  set  aside  in  so  many  dollars 
and  cents,  or  equivalent  assets.  It  is  based,  of  course,  primarily 
on  the  theory  which  the  sinking-fund  calculation  raises,  namely: 

199 


Principles  of  Accounting 

the  sum  which  must  be  set  aside  annually,  at  compound  interest, 
in  order  to  equal  at  maturity  the  desired  amount.  Such  would 
be  the  case  with  regard  to  depreciation  if  it  were  desired  to 
replace  physically  the  asset  depreciated.  It  is  not  necessary, 
however,  that  this  be  done.  The  question  to  be  determined  is 
what  amount  shall  be  annually  charged  to  operating  expenses. 
The  answer  to  the  question  is,  therefore,  such  an  amount  as 
would  annually,  at  compound  interest,  amount  to  the  value  of 
the  asset  to  be  written  off.  The  marked  objection  to  the  sinking- 
fund  method  is  that  each  time  there  is  an  addition  to  or  deduc- 
tion from  the  original  cost  of  the  asset  the  sinking-fund  calcula- 
tion is  destroyed,  and  it  becomes  necessary  to  revise  it.  The 
following  tables,  charts  and  calculations  show  the  relative  advan- 
tages and  disadvantages  of  the  three  methods  above  described, 
as  well  as  others  mentioned: 


200 


Depreciation 


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20I 


Principles  of  Accounting 

In  connection  with  the  methods  just  previously  mentioned 
it  will  be  noted  that  any  addition  to  or  reduction  from  the  original 
asset  will  disturb  the  calculation  seriously,  except  in  the  case 
of  the  flat  rate.  Addition  to  a  given  asset  will  have  no  effect 
upon  the  rate  if  the  addition  is  of  the  same  life  as  the  original 
asset.  Naturally,  a  deduction  from  the  original  asset  will  have 
no  effect  upon  the  rate.  It  will  thus  be  seen  that  the  life  plays 
a  very  important  part  in  the  calculation  of  depreciation.  If  all 
property  were  of  the  same  life,  additions  and  deductions  would 
have  no  effect  upon  the  rate.  The  amount  would,  of  course, 
change.  For  example:  A  given  asset,  costing  $600,  without 
residual  value,  might  have  an  estimated  life  of  ten  years.  In 
consequence,  $60  would  be  the  amount  of  the  annual  deprecia- 
tion. If  at  the  end  of  the  second  year  a  portion  of  the  asset, 
corresponding  to  one-third,  for  example,  were  to  be  sold,  the 
asset  would  be  reduced  to  the  extent  of  $200,  and  while  the 
amount  of  the  annual  depreciation  would  be  decreased  to  $40 
the  rate  would  not  change.  It  would  still  be  10  per  cent,  on 
the  remainder  of  $400.  The  converse  of  this  proposition  might 
be  illustrated  by  a  case  wherein  the  original  cost  of  the  asset  is 
$600,  with  the  annual  depreciation  charge  of  $60.  Again,  if  at 
the  end  of  the  second  year  additions  to  the  extent  of  $75  are 
applied,  the  annual  charge  will  be  $67.50  instead  of  $60,  corre- 
sponding to  10  per  cent,  of  the  cost  of  the  asset,  namely,  $675. 
Attention  should  be  drawn  to  the  fact  that  in  neither  of  these 
cases  will  it  make  any  difference  whether  the  addition  or  deduc- 
tion takes  place  at  the  end  of  the  second  or  some  subsequent 
year.  The  vital  point  is  that  the  additions  and  deductions  must 
correspond  in  life  to  the  original  asset.  For  this  reason  it  becomes 
almost  impossible  to  compute  depreciation  from  the  asset  accounts 
in  the  general  ledger.  Where  attention  is  given  to  depreciation, 
and  an  attempt  is  made  to  compute  it  systematically,  the  details 
of  the  general  ledger  property  accounts  will,  almost  invariably, 
be  found  in  underlying  ledgers  or  memorandum  books.  Unless 
the  assets  are  classified  with  regard  to  their  respective  estimated 
lives,  when  the  calculation  consists  merely  in  taking  the  total 
cost  less  the  estimated  residual  value  in  each  class,  and  applying 
the  rate  determined  by  the  estimated  life,  there  will  at  once  arise 
the  question  as  to  when  the  life  begins  and  whether  or  not  the 
beginning  should  correspond  accurately  with  the  date  of  acqui- 

202 


Depreciation 

sition  of  the  asset.  For  example:  In  the  case  of  a  piece  of 
machinery,  purchased  on  the  twentieth  of  November,  in  a  given 
year.  Shall  the  life  begin  on  the  twentieth  of  November,  or 
shall  it,  for  purposes  of  convenience  in  the  calculation  of  depre- 
ciation, be  considered  as  of  the  first  of  the  following  January? 
To  repeat  the  question  in  general  terms,  shall  additions  to  prop- 
erty during  a  given  year  be  taken  up,  for  purposes  of  deprecia- 
tion, from  the  actual  dates  of  acquisition  or  from  the  end  of  the 
year  in  which  they  were  acquired?  Generally  speaking,  it  is 
proper  to  wait  until  the  end  of  the  year  before  putting  additions 
to  property  on  a  depreciation  basis.  While  this  will  probably 
be  found  to  be  the  general  practice,  there  will  undoubtedly  be 
exceptions  to  the  rule  in  special  cases  where  certain  assets  depre- 
ciate rapidly.  In  the  case  of  concerns  closing  their  books  oftener 
than  once  a  year  it  is  usually  customary  to  begin  the  depreciation 
as  at  the  end  of  the  period  in  which  the  property,  or  additions 
thereto,  were  acquired. 

As  to  the  manner  of  treating  depreciation  in  accounts,  there 
are  two  ways.  One  is  to  write  down  the  asset  to  profit  and  loss ; 
the  other  is  to  make  provision  for  depreciation  through  a  charge 
to  profit  and  loss  and  the  creation  of  a  reserve.  In  the  first  case, 
granting  that  a  certain  machine  cost  $10,000,  that  the  estimated 
residual  value  is  $500,  and  the  estimated  life  ten  years,  the 
journal  entry  at  the  end  of  the  first  year  would  be  as  follows : 

Profit  and  loss  or  (depreciation) >    $950.00 

To  Machinery $950.00 

In  the  second  case,  where  the  asset  is  not  written  down,  but  its 
value  depreciated  or  oflfset  by  a  reserve,  the  journal  entry  would 
be  as  follows: 

Profit  and  loss  or   (provision  for  de- 
preciation)       $950.00 

To  Reserve  for  depreciation $950.00 

The  second  method  seems  to  have  distinct  advantages  over  the 
first  method,  in  that  it  permits  the  asset  to  stand  at  its  original 
cost,  plus  additions  or  deductions,  while  its  value  is  offset  by  a 
reserve,  whereas  in  the  first  case  the  balance  in  the  account 
results  from  a  series  of  transactions  representing  original  cost, 
additions,  deductions  and  amounts  written  off.    It  is,  therefore, 

203 


Principles  of  Accounting 

difficult  to  determine,  except  through  analysis,  whether  the  credits 
in  the  account  are  for  sales,  losses,  or  damage  to  the  assets,  or 
amounts  written  off  for  depreciation.  This  would,  perhaps,  make 
little  difference  if  all  the  details  of  an  asset  account  were  carried 
forward  from  year  to  year,  but  where  new  books  are  opened 
yearly  the  original  cost  of  the  asset  is  soon-  lost  track  of.  This 
point  might  be  an  important  matter  in  the  case  of  a  prospective 
sale,  and  while,  of  course,  the  original  cost  could  be  determined 
by  an  analysis  of  the  old  accounts,  it  would  seem  to  be  very  much 
easier,  and  more  satisfactory,  to  carry  the  asset  forward  from 
year  to  year  at  its  original  cost,  plus  actual  additions  and  minus 
actual  deductions,  so  that  the  cost  would  always  appear  in  the 
current  books;  whereas  the  book  value,  being  the  difference 
between  the  cost  and  the  reserve,  could  also  be  easily  determined. 
It  also  happens,  in  certain  cases,  that  a  concern  will  desire 
to  put  aside  a  fund  out  of  which  to  replace  the  assets  at  the  end 
of  their  respective  lives.  Where  a  provision  for  depreciation 
has  been  made  through  the  medium  of  a  reserve  this  is  known 
as  funding  the  reserve.  The  idea  back  of  this  scheme  is  that  a 
fund  will  be  accumulated  from  time  to  time  which  will  be  suffi- 
cient, at  the  expiration  of  the  life  of  the  asset,  to  replace  it.  The 
fund  may,  of  course,  be  accumulated  without  the  creation  of  a 
reserve,  but  the  effect  at  the  expiration  of  the  life  of  the  asset 
is  precisely  the  same.  In  the  one  case,  namely,  where  the  asset 
has  been  written  off  over  a  period  of  years  to  profit  and  loss, 
it  will,  presumably,  have  disappeared  at  the  end  of  its  estimated 
life.  There  will  then  stand  in  place  of  it  the  accumulated  fund. 
In  the  other  case  the  asset  will  remain;  the  reserve  will  have 
been  created  to  an  extent  which  equals  the  asset;  the  asset,  at 
the  end  of  its  life,  will  be  closed  out  to  the  reserve;  and  the 
fund  will  stand  in  place  of  the  asset.  The  accumulation  of  a 
fund  is,  of  course,  conservative,  and  offers  an  opportunity  for 
setting  aside  a  small  amount  annually  instead  of  being  obliged 
to  provide  perhaps  a  large  amount  for  replacement  suddenly. 
The  objection  found  to  accumulating  a  fund  is  that  almost  any 
prosperous  concern  can  make  more  money  through  the  use  of 
the  cash  in  the  business  than  a  fund  would  return  in  the  way  of 
interest.  It  would,  therefore,  be  found  that  in  a  prosperous 
concern,  which  might  reasonably  expect  to  have  on  hand  suffi- 
cient funds  for  replacement  at  any  given  time,  the  accumulation 

204 


Depreciation 

of  a  fund  would  be  unnecessary.  So  long  as  the  annual  profits, 
are  reduced  by  a  provision  for  depreciation  it  would  appear  that 
the  matter  had  been  conservatively  handled. 

Many  text-books  discuss  the  creation  of  a  reserve  for  depre- 
ciation, but  very  few  have  anything  to  say  concerning  its  dispo- 
sition. In  the  case  above  cited,  where  the  cost  of  machinery 
was  $io,cx)0,  the  residual  value  estimated  at  $500,  and  the  esti- 
mated life  was  ten  years,  it  will  be  recalled  that  the  annual 
charge  for  depreciation  was  $950.  If  depreciation  were  to  be 
provided  for  through  the  medium  of  a  reserve,  at  the  expiration 
of  the  life  of  the  machinery  the  reserve  would  show  credits 
aggregating  $9,500.  The  difference  between  the  cost  and  the 
reserve  would  be  $500.  Two  things  might  at  this  time  happen, 
namely :  the  machinery  continue  in  use,  or  be  sold  as  second-hand 
or  scrap.  Although  practically  written  off,  its  usefulness,  while 
impaired,  might  warrant  its  continuance  in  use,  and  for  all  prac- 
tical purposes  it  might  apparently  be  worth  as  much  to  the  con- 
cern as  it  ever  was.  The  accounts  might  be  allowed  to  stand  as 
stated,  giving  to  the  asset  a  nominal  value  of  $500.  If  its  earning 
power  were  still  as  great  as  before,  the  value  is  obviously  greater 
than  $500.  Such  a  case  has  sometimes  been  given  as  an  example 
of  a  secret  reserve.  This  would,  of  course,  be  true  whether  or. 
not  the  accounts  were  allowed  to  stand  or  whether  the  reserve 
was  closed  out  to  the  asset  and  the  book  value  thereof  shown 
as  $500. 

Assuming  the  latter  steps  to  have  taken  place,  and  the  ma- 
chinery to  have  been  sold,  then  one  of  two  things  may  result. 
First,  the  asset  may  have  been  sold  for  more  than  $500;  and 
second,  for  less  than  $500.  Assuming  the  sale  to  have  brought 
$800,  the  transaction,  expressed  in  the  form  of  journal  entry, 
would  then  appear  as  follows : 

Cash  or  (accounts  receivable) $800.00 

To  Machinery $500.00 

Profit  and  loss 300.00 

If,  perchance,  the  asset  realized  only  $400,  the  entry  would  be 
as  follows: 

Cash  $400.00 

Profit  and  loss 100.00 

To  Machinery $500.00 

205 


Principles  of  Accounting 

In  case  the  original  asset  has  been  allowed  to  stand  and  a 
reserve  created,  the  closing  entry,  that  is,  the  one  required  to 
bring  the  asset  down  to  its  residual  value,  would  be  as  follows: 

Reserve  for  depreciation  of  machinery. .     $9,500. 

To  Machinery $9,500. 

The  balance  in  the  account  would  then  be  $500.  As  such  it 
might  remain  or  be  treated  as  suggested  in  the  preceding  entries 
recording  the  disposition. 

It  should  be  borne  in  mind  in  connection  with  depreciation, 
and  as  a  parting  thought,  that  it  is,  at  best,  an  estimate;  that  it 
rarely  works  out  as  planned,  and  that  taking  it  into  consideration 
is  only  an  attempt  to  (a)  properly  state  the  estimated  value  of  an 
asset  and  (b)  provide  for  proper  charges  to  operations. 

It  might  also  be  mentioned,  of  course,  that  incidentally  infor- 
mation concerning  depreciation  may  be  of  value  in  securing  accu- 
rate cost  data  and  determining  the  relative  efficacy  of  different 
types  of  construction  or  equipment.  The  fact  is  not  to  be  ignored, 
either,  that  the  federal  corporation  tax  law  requires  all  corpora- 
tions to  include  depreciation  as  an  item  of  expense. 

REFERENCES  FOR  COLLATERAL  READING: 

Modern  Accounting,  Hatfield,  Chapter  VII. 

Accounting  in  Theory  and  Practice,  Lisle,  page  137. 

Accounts,  Their  Construction  and  Interpretation,  Cole,  pages 
247-257. 

Science  of  Accounts,  Bentley,  pages  139-149. 

Electric  Light  Accounts,  Edwards,  Chapter  V. 

Accounting,  Practice  and  Procedure,  Dickinson,  pages  164- 
174,  221. 

Depreciation  and  Wasting  Assets,  Leake. 

Engineering  Valuation  of  Public  Utilities  and  Factories,  Fos- 
ter. 

Factory  Costs,  Webner,  Chapter  XIV. 

Journal  of  Accountancy,  Vol.  XVI,  page  358. 

Journal  of  Accountancy,  Vol.  XV,  page  106. 

Journal  of  Accountancy,  Vol.  XIV,  page  431. 

Journal  of  Accountancy,  Vol.  IX,  pages  89,  189. 


206 


CHAPTER   XXXII 

INTEREST 

The  commonly  accepted  definition  of  interest  is  "Money  paid 
for  the  use  of  money."  The  late  Colonel  Sprague,  who  perhaps 
gave  more  thought  to  the  subject  of  interest  than  any  other  man 
who  has  written  on  the  subject,  took  a  somewhat  different  view. 
He  defined  interest  in  substance  as  "The  increase  in  principal  due 
to  lapse  of  time."  For  the  purposes  of  this  discussion,  however, 
it  does  not  seem  to  be  necessary  to  attempt  the  reconciliation  of 
these  somewhat  divergent  definitions,  since  there  is  probably  no 
question  in  any  student's  mind  as  to  what  constitutes  interest. 
The  reason  for  interest  is  that  some  one  has  borrowed  capital  or 
funds,  and  for  the  use  of  these  funds  some  one  is  obliged  to  pay 
interest.  Without  regard  at  present  as  to  whether  interest  is  to 
be  regarded  as  an  item  of  income  or  an  item  of  expense,  there 
are  certain  characteristics  of  interest  which  are  common  to  both 
and  which  must  be,  for  the  purpose  of  discussion,  first  stated. 
These  characteristics  are,  namely :  principal,  rate  and  time.  The 
question  of  principal  and  rate  require  no  particular  discussion. 
The  question  of  time  is  the  one  which  vitally  affects  the  compu- 
tation of  interest  and,  consequently,  the  bases  or  methods  of  cal- 
culation. Generally  speaking,  these  methods,  in  so  far  as  simple 
interest  is  concerned,  are  confined  to  three,  namely:  the  360-day 
basis,  the  365-day  basis  and  what  is  generally  regarded  as  the 
legal  method.  The  first-named  consists  in  dividing  the  interest 
for  a  year  by  360  and  considering  I -360th  as  the  amount  appli- 
cable to  each  day.  The  second  consists  in  dividing  the  interest 
for  a  year  by  365  and  considering  i -365th  as  the  amount  applicable 
to  each  day.  The  legal,  method,  which  is  the  construction  geni- 
ally placed  upon  the  statutes  now  in  force,  consists  in  dividing 
the  interest  for  a  year  by  12  and  considering  i-i2th  as  the  amount 
applicable , to  each  month.  Odd  days  are  treated  as  365ths  of  a 
year. 

The  legal  day  begins  and  ends  at  midnight.  Therefore,  in  com- 
puting interest  for  a  given  number  of  'days  the  first  day  should  be 
excluded  and  the  last  day  included,  or  vice  versa.  Colonel 
Sprague    advocated    "qpunting   the    nights."     In    applying   the 

207 


Principles  of  Accounting 

methods  above  described  a  concrete  example  may  prove  beneficial. 
Let  the  statement  of  facts  be  as  follows:  Principal,  $i,ooo;  rate, 
6  per  cent;  period,  February  21  to  March  27.  The  year's  interest 
vvill  amount  to  $60.  Using  the  360-day  basis,  the  interest  per  day 
will  be  $.166.  The  number  of  days  elapsed  between  February 
21  and  March  24  will  be  34.  The  amount  of  interest  will,  there- 
fore, be  $5.64.  Using  the  365-day  basis,  the  interest  per  day  will 
be  $.164.  The  number  of  days  elapsed  between  February  21  and 
March  2y  will  be  34.  The  amount  of  interest  will,  therefore,  be 
$5.57.  Using  the  legal  method  the  time  will  be  i  month,  6  days. 
The  interest  for  the  i  month  will  be  i-i2th  of  $60,  or  $5.  The 
interest  for  the  6  days  will  be  6-365ths  of  $60,  or  $.98,  making 
the  interest  for  the  time  elapsed  between  February  21  and  March 
2y  $5.98.  The  360-day  basis  is  probably  the  most  general  basis 
used,  since  it  is  easiest.  Banks  and  brokers  generally  use  it. 
However,  it  is  said  of  some  banks  and  trust  companies  that  they 
charge  interest  on  the  360-day  basis  and  pay  interest  on  the 
365-day  basis.  The  365-day  basis  is  used  generally  by  accountants 
whose  desire  it  is  to  be  as  accurate  as  possible.  The  legal  rate 
is  used  in  computing  interest  on  judgments  and  wherever  interest 
is  involved  in  judicial  actions  and  decisions. 

To  take  up  now  interest  as  affecting  the  accounts  of  a  given 
organization  we  find  that  interest  may  be  related  to  the  accounts 
either  as  income  or  expense.  As  an  item  of  income,  it  may  appear 
as  interest  on  bonds  owned,  interest  on  bonds  and  mortgages  re- 
ceivable, interest  on  bank  balances,  interest  on  accounts  receiv- 
able, and  interest  on  notes  receivable.  As  an  expense  it  may 
appear  in  connection  with  bond  and  mortgage  payable,  deben- 
tures, income  bonds,  accounts  payable,  notes  payable,  or  loans 
payable.  In  isolated  cases  it  may  appear  as  interest  on  capital, 
especially  in  the  case  of  copartnerships.  It  accrues  over  a  period 
of  time,  and  in  accordance  with  such  accrual  must  be  taken  into 
the  accounts  at  closing  dates  whether  or  not  it  has  been  actually 
paid  or  collected.  As  an  earning  or  item  of  income  we  have  it 
charged  to  some  asset  account  and  taken  into  the  income  for  the 
period.  As  an  item  of  expense  we  have  it  charged  against  the 
expenses  of  the  period  and  credited  to  a  liability  account.  Sub- 
sequent receipt  or  payment  of  the  interest  in  cash  will  not  affect 
in  any  way  the  income-  or  expense  items.  The  cash  received  sub- 
sequent to  the  accrual  appears  in  the  light  of  a  realization  of  the 

208 


Interest 

asset,  accrued  interest.  The  payment  of  the  cash  for  interest 
subsequent  to  the  accrual  of  the  interest  appears  in  the  light  of 
a  liquidation  of  the  liability,  interest  accrued.  It  might  be  said 
here  that  for  convenience  many  accountants  have  adopted  a 
nomenclature  which  will  distinguish  between  interest  accrued  as 
an  asset  and  interest  accrued  as  a  liability.  The  distinction  con- 
sists in  using  the  word  accrued  before  the  word  interest  for  the 
purpose  of  denoting  an  asset,  whereas  for  the  purpose  of  denoting 
a  liability  the  word  accrued  follows  the  word  interest. 

To  run  through  one  or  two  sets  of  typical  transactions  for  the 
purpose  of  illustrating  the  entries  in  connection  with  interest,  we 
may  take  the  following  statement  of  facts : 

Principal  of  a  note  received  from  customer $i,ooo 

Rate  of  interest 6  per  cent. 

Date  of  note June  i 

Period 3  months 

Basis  (for  convenience  in  illustration) 360-day 

Closing  date June  30 

Note  paid September  i 

The  interest  on  the  note  will  be  $5  per  month.  In  closings  the 
books  at  June  30  the  entry  will  be  as  follows : 

Accrued  interest $5-00 

To  Interest  earned $5.00 

Upon  the  settlement  of  the  note  on  September  i,  the  following 
entry  will  appear : 

Cash $1,015.00 

To  Notes  receivable $1,000.00 

Accrued  interest 5.00 

Interest   earned 10.00 

A  variation  of  this  procedure  might,  of  course,  take  place  if 
before  making  the  final  entry  the  interest  transaction  were  com- 

209 


Principles  of  Accounting 

pleted,  namely :  by  charging  accrued  interest  and  crediting  interest 
earned  with  $io.  The  entry  corresponding  to  the  above  would 
then  appear  as: 

Cash $1,015.00 

To  Notes  receivable $1,000.00 

Accrued  interest 15.00 

If  the  above  statement  of  facts  may  be  similarly  used  to  illus- 
trate the  entries  in  the  case  of  notes  payable  instead  of  notes 
receivable,  the  entry  at  June  30  would  then  appear : 

Interest  expense $5.00 

To  Interest  accrued $5.00 

At  the  time  of  paying  the  note  the  entry  would  appear : 

Notes  payable $1,000.00 

Interest  accrued 5.00 

Interest  expense 10.00 

To  Cash $1,015.00 

The  same  variation  as  was  above  indicated  in  the  case  of  notes 
receivable  might  occur  here,  namely:  that  the  interest  might  be 
fully  accrued  at  the  time  of  payment  before  the  entry  for  the 
cash  transaction  was  made.  The  final  entry  under  such  circum- 
stances would  then  be : 

Notes  payable $1,000.00 

Interest  accrued 15.00 

To  Cash $1,015.00 

It  would  seem  as  though  this  were  an  appropriate  place  to 
discuss  discount,  on  account  of  the  close  relation  which  it  bears 
to  interest,  being  considered,  in  fact,  as  interest  paid  before  it  is 
due.  Discount  is  of  two  kinds :  bank  discount  and  true  discount. 
Bank  discount  is  simple  interest  collected  in  advance.  True  dis- 
count is  compound  interest  collected  in  advance,  or  the  difference 
between  the  amount  of  the  principal  and  its  present  worth.  The 
bank  discount  on  $1,000  at  6  per  cent,  for  one  year  would  be  $60. 
The  true  discount  on  the  same  amount  for  the  same  time  and 

210 


Interest 

rate  would  be  $56.61.  The  bank  discount  is  obtained  by  multi- 
plying $1,000  by  6  per  cent.,  whereas  the  true  discount  is  ascer- 
tained by  dividing  i  by  1.06,  the  result  of  which  will  give  the 
present  worth  of  a  dollar  at  6  per  cent,  compound  interest  for 
one  year.  The  present  worth  of  $1  multiplied  by  $1,000  will  give 
$943.39.  This  sum  subtracted  from  the  principal  of  $1,000  shows 
the  discount  of  $56.61. 

Mr.  H.  C.  Bentley,  C.P.A.,  in  his  book  on  the  "Science  of 
Accounts"  makes  a  distinction  between  interest  and  discount 
which  is  logical  if  somewhat  novel.  Mr.  Bentley  holds  that  bank 
discount  should  never  be  called  discount.  He  is  of  the  opinion 
rather  that  where  collected  in  advance  it  should  be  called  simply 
interest  paid  in  advance. 

Such  a  distinction  would  help  considerably  to  clarify  matters 
since  discount  would  then  mean  but  one  thing.  In  the  case  of 
the  three  months'  note  previously  referred  to,  the  interest  would 
be  $15.00;  the  discount  $14.78.  The  interest  might  be  paid  in 
advance  or  at  maturity;  discount  would  always  be  collected  in 
advance.  Under  such  circumstances  it  would  be  unnecessary 
to  distinguish  between  bank  discount  and  true  discount.  Why 
banks  prefer  the  former  is  not  difficult  to  see. 

If  we  accept  the  suggestion  that  discount  should  mean  but  one 
thing,  then  the  only  question  in  so  far  as  our  accounting  is 
concerned  is  the  relation  of  this  discount  to  the  accounting 
periods.  In  treating  with  discount  we  must  look  at  it  from  two 
points  of  view — one,  that  of  the  party  who  pays  the  discount; 
the  other,  the  party  who  receives  the  discount.  Taking  up  first 
the  point  of  view  of  the  party  paying  the  discount,  it  then  ap- 
pears that  interest  has  been  paid  for  the  use  of  money  covering  a 
period  which  has  not  yet  elapsed.  The  interest,  or  discount,  is, 
therefore,  appropriately  and  properly  to  be  considered  as  a  pay- 
ment in  advance.  Consequently,  it  should  be  treated  as  a  deferred 
charge  to  expense.  As  the  time  elapses  over  which  this  prepay- 
ment extends  the  deferred  charge  to  expense  should  be  gradually 
reduced  by  charges  to  expense.  In  the  case  of  the  note  on  which 
the  discount  was  $14.78,  the  original  discounting  of  the  note, 
stated  in  terms  of  journal  entries,  would  be  as  follows : 

Cash $985.22 

Discount  14.78 

To  Notes  payable $1,000.00 

211 


Principles  of  Accounting 

The  item  of  $14.78  will  subsequently  be  charged  to  interest 
expense,  or  interest  on  notes  payable,  and  credited  to  discount 
as  the  time  elapses.  At  June  30,  assuming  that  the  note  was 
discounted  on  June  i,  $4.87  of  this  amount  will  be  charged  to 
the  expense  for  the  month,  while  the  remaining  $9.91  will  appear 
in  the  balance  sheet  as  a  deferred  charge. 

The  opposite  of  the  above  is  true  and  applies  especially  to 
banks  and  banking  institutions.  If,  in  the  first  case,  the  man 
who  stands  the  discount  is  entitled  to  defer  the  charge  to  his 
expenses  in  accordance  with  the  extent  to  which  the  period 
covered  has  elapsed,  then  surely  the  recipient  of  the  discount 
must  not  take  into  his  earnings  the  entire  amount.  The  bank 
or  banker  discounting  notes  should  set  up  discount  as  a  deferred 
credit  to  income  under  the  head  of  discount  unearned  and  take 
same  into  its  earnings  in  accordance  with  the  lapse  of  time.  To 
use  again  the  same  illustration,  the  entry  for  the  bank  will  be, 
upon  discounting  the  note : 

Notes  receivable $1,000.00 

To  Discount  unearned $  14.78 

Cash   985.22 

At  the  end  of  the  month  an  entry  should  be  made  charging 
discount  unearned  and  crediting  discount  earned  with  $4.87  of 
the  discount.  There  would  then  appear  in  the  discount  earned 
for  the  period  $4.87  and  as  a  deferred  credit  to  income  on  the 
balance  sheet  $9.91. 

The  question  of  setting  up  the  unearned  discount  is  not,  as  a 
rule,  important  in  a  mercantile  concern  for  the  reason  that,  like 
so  many  other  items,  the  results  of  taking  it  into  consideration 
are  not  worth  the  energy  and  trouble  expended  in  so  doing.  In 
the  case  of  a  bank  or  banker,  a  large  part  of  whose  business  con- 
sists in  discounting  paper,  the  situation  would  be  quite  different. 
It  is  of  utmost  importance  in  such  cases  that  careful  attention 
be  given  to  the  matter  of  unearned  discount.  Banks  which  close 
their  books  annually  or  semi-annually  will  tell  you  that  the  dis- 
count will  average  up  between  periods  and  that  it  is  not  necessary 
to  observe  the  rule  with  regard  to  taking  the  earnings  on  discount 
into  income.    Thus  it  might  easily  happen  in  the  case  of  a  bank 

212 


Interest 

closing  \ii  books  monthly  or  quarterly  that  there  would  be  a 
marked  fluctuation  in  the  income  among  the  different  quarters. 
The  decrease  in  any  given  period  would  probably  be  attributed 
off-hand  to  a  falling  off  of  business.  This  might,  of  course,  be 
true.  On  the  other  hand,  it  might  also  be  true  that  the  money 
value  of  the  notes  discounted  had  increased  rather  than  decreased, 
but  that  the  average  term  which  the  various  notes  had  to  run  was 
so  much  shorter  than  the  average  term  of  notes  discounted  in 
the  preceding  period  as  to  more  than  offset  the  increase  in  the 
discount  resulting  from  the  increase  in  the  amount  of  the  notes. 
If  the  discount  were  properly  spread  over  the  life  of  the  notes 
a  situation  such  as  the  above  could  not  exist.  An  increase  or 
decrease  in  the  earnings  from  discount  as  among  periods  would 
then  represent  the  true  fluctuation  in  the  volume  of  notes 
discounted. 

While  the  matter  of  setting  up  the  unearned  discount  is 
one  of  considerable  trouble  to  banks  which  are  particular  about 
this  point  some  of  them  have  devised  means  of  facilitating  their 
work  in  this  respect.  Ordinarily  it  is  probable  that  they  would 
ascertain  their  unearned  interest  at  the  end  of  a  given  period  in 
the  same  manner  in  which  an  accountant  is  obliged  to  ascertain 
such  information  when  he  goes  in  to  make  an  audit  or  examina- 
tion, namely :  by  listing  the  discounted  notes  and  figuring  on  each 
note  the  unexpired  discount  collected  in  advance.  This  then 
would  be  charged  to  discount  earned,  or  interest  and  discount, 
and  credited  to  discount  unearned,  or  interest  received  in  advance. 
To  avoid  this  laborious  process  some  banks,  as  has  just  been 
suggested,  keep  what  is  known  as  a  discount  register.  This  book 
is  somewhat  similar  to  the  ordinary  notes  payable  or  notes  re- 
ceivable books  so  common  among  mercantile  concerns.  In  it  the 
notes  are  listed  and  the  particulars  concerning  them,  including 
the  amount  of  each  and  the  discount  on  each.  The  discount  is 
then  spread  over  a  series  of  columns  corresponding  to  the  months 
in  accordance  with  the  number  of  months  the  respective  notes 
have  to  run.  While  this  practice  is  comparatively  rare,  it  would 
probably  be  still  rarer  to  find  a  bank  spreading  its  discount  scien- 
tifically; that  is,  increasing  gradually  from  month  to  month  as 
the  time  elapsed.  While  admittedly  not  scientific,  it  is  probably 
satisfactory  to  divide  the  discount  by  the  number  of  months  the 
note  has  to  run  and  credit  to  each  month  its  proportionate  share. 

213 


Principles  of  Accounting 

It  will  be  seen  that  by  the  use  of  this  method  all  discount  will  be 
credited  immediately  to  an  unearned  account,  but  will  be  credited 
to  earnings  monthly  by  an  entry  charging  discount  unearned  and 
crediting  discount  earned  in  an  amount  corresponding  to  the 
footing  in  the  discount  register  for  any  given  month. 

Another  expedient  for  facilitating  the  accruing  of  interest  may 
also  be  mentioned  at  this  time.  Organizations  holding  numerous 
securities  on  which  interest  accrues  find  the  computing  of  the 
interest  a  source  of  considerable  trouble.  Here  again  the  interest 
must  be  computed  either  at  the  end  of  the  period  on  the  particular 
securities  or  investments  owned  individually  or  through  the  means 
of  a  register  in  which  the  interest  on  each  security  for  the  month 
is  set  up.  As  a  variation  from  both  of  these  methods  it  sometimes 
becomes  possible  to  classify  the  par  principal  according  to  the 
various  rates  of  interest,  namely:  4  per  cent.,  4^4  P^r  cent.,  5 
per  cent.,  etc.,  and  accrue  the  interest  on  the  total  amount  of 
principal  in  each  class  at  any  time.  For  example:  Assuming 
that  a  given  concern  had  $100,000  4  per  cent,  bonds,  $50,000  4}^ 
per  cent,  bonds,  $200,000  5  per  cent,  bonds,  another  $200,000  of 
4  per  cent,  bonds,  another  $50,000  4^  per  cent,  bonds,  instead 
of  accruing  the  interest  of  five  separate  items,  the  two  lots  of  4 
per  cent,  bonds  would  be  added  and  the  accrued  interest  at  4  per 
cent,  computed  on  the  total.  In  the  same  way  the  4}^  per  cent, 
bonds  would  be  added  and  the  interest  accrued  on  the  total.  Then 
by  accruing  the  interest  on  the  5  per  cent,  bonds  there  would  be 
three  calculations  instead  of  five.  If  this  illustration  may  now  be 
applied  to  a  large  organization  in  which  a  great  many  different 
securities  are  held,  the  value  of  such  a  method  will  be  apparent. 
In  order  to  employ  this  method  it  is  necessary  to  keep  a  register 
in  which  the  securities  are  entered  in  accordance  with  the  rate 
of  interest  which  they  bear.  It  is,  of  course,  evident  that  broken 
periods,  resulting  from  purchases  or  sales  of  securities,  except  at 
the  end  of  the  accrual  periods,  will  upset  the  calculations  unless 
the  items  in  question  are  deducted  from  the  totals  and  the  interest 
accrued  on  these  items  separately. 

In  the  matter  of  copartnerships  interest  of  capital  becomes 
an  important  factor.  Ordinarily  it  seems  that  nothing  is  to  be 
gained  by  charging  the  business  with  interest  on  capital  and  taking 
it  in  as  an  earning.  This  has  too  much  the  appearance  of  doing 
business  with  one's  self.    It  would  seem  hardly  necessary  to  add 

214 


Interest 

that  no  money  is  ever  made  in  this  way.  Some  economists  under- 
take to  analyze  the  profit  of  a  business  organization  and  classify 
it  with  regard  to  the  factors  which  produce  it.  In  this  way 
capital  is  shown  to  have  earned  interest.  This  would  seem  to  be 
an  unnecessary  procedure  and  tend  to  confusion  rather  than 
otherwise.  It  is  conceded  that  statistical  information  concerning 
the  employment  of  capital  and  the  return  therefrom  is  at  times  of 
value  to  the  administrative  force.  There  would  seem  to  be  no 
reason,  however,  why  the  general  books  and  accounts  of  the  or- 
ganization should  be  burdened  with  carrying  and  showing  this 
information.  It  would  seem  rather  to  be  a  matter  for  independent 
calculation.  In  the  case  of  a  copartnership,  however,  where 
certain  conditions  exist,  the  situation  becomes  quite  different. 
Here  many  times  the  amount  which  the  respective  partners  are 
credited  with  will  depend  upon  the  matter  of  interest  on  capital. 
The  following  three  rules  may  be  given  concerning  when  it  is 
proper  to  charge  and  credit  interest: 

(i)  When  the  capital  is  unequal  and  the  profits  are  to  be 
equally  divided,  charge  interest  on  capital  and  credit  the  respective 
drawing  accounts  of  the  partners. 

(2)  When  the  capital  is  unequal  and  the  profits  are  to  be 
unequally  divided,  charge  interest  on  capital  and  credit  the  re- 
spective drawing  accounts  of  the  partners. 

(3)  When  the  capital  is  equal  and  the  profits  are  to  be 
unequally  divided,  charge  interest  on  capital  and  credit  the  re- 
spective drawing  accounts  of  the  partners. 

Where  the  capital  is  equal  and  the  profits  are  to  be  equally 
divided,  nothing  is  gained  by  charging  and  crediting  interest. 

The  following  ledger  accounts  will,  it  is  hoped,  make  clear  the 
reasons  for  the  above  rule: 

First  proposition.  Share  profits  J4  and  J^ ;  capital  unequal. 
Interest  6%. 

A  B  Profit  and  Loss 


P&L  $3,000 


$60,000     P&L  $3,000 
I.  3,600 


$40,000     Int.  $6,000 1 A  $3 ,000 
I.  2,400  B    3,000 


Second  proposition.    Share  profits  2/3  and  1/3 ;  capital  unequal. 
Interest  6%, 

215 


Principles  of  Accounting 

B  Profit  and  Loss 


P&L  $4,000  I  $60,000     P&L  $2,000 
I.  3,600 


$40,000     Int.  $6,000 
I.  2,400 


A  $4,000 
B    2,000 


Third  proposition.    Share  profits  2/3  and  1/3;  capital  equal. 
Interest  6%. 

A  B  Profit  and  Loss 


P&L  $4,000 


$50,000     P&L  $2,000 
I.  3,000 


$50,000     Int.  $6,000 
I.  3,000 


A  $4,000 
B    2,000 


Fourth  proposition.     Share  profits  J/2  and  J/2 ;  capital  equal. 
Interest  6%. 

Profit  and  Loss 


B 


P&L  $3,000 


$50,000    P&L  $3,000 
I.  3,000 


$50,000     Int.  $6,000 
I.  3,000 


A  $3,000 
B    3,000 


REFERENCES  FOR  COLLATERAL  READING! 

Journal  of  Accountancy,  Vol.  XV,  pages  231,  236,  240,  241, 
329.  330,  334,  427,  428,  431 ;  Vol.  XVI,  pages  89,  145,  22. 

Philosophy  of  Accounts,  Sprague,  Chapters  XII  and  XIII. 


;i6 


CHAPTER   XXXIII 

INSURANCE 

Insurance  may  be  defined  as  a  contract  whereby,  in  considera- 
tion of  a  premium  paid  by  one  party  to  another,  the  former  is 
protected  by  the  latter  from  loss.  Insurance  may  be  of  various 
kinds :  Life,  fire,  accident,  health,  marine,  credit,  burglary,  fidelity 
and  surety,  employers'  liability,  etc.  The  accountant  is  little  con- 
cerned with  the  nature  of  the  insurance.  What  does  affect  him 
directly  is  what  relation  a  loss  and  corresponding  settlement  bears 
to  the  accounting,  and  in  a  similar  manner  what  relation  the 
premiums  paid  bear  to  the  accounting.  It  is  true,  of  course,  that 
he  should  have  a  more  or  less  general  idea  of  the  nature  and 
operation  of  the  various  kinds  of  insurance  contracts  referred 
to,  for  which  reason  they  are  briefly  described  here. 

Life  insurance  is  not  usually  involved  in  the  accounts  of  an 
organization.  It  is  true  that  some  proprietors  may  be  found  who 
make  a  practice  of  merging  their  private  with  their  business 
affairs  and  accounts ;  however,  this  is  not  to  be  countenanced  as 
good  practice.  In  such  cases,  of  course,  instances  have  been 
known  where  sole  proprietors  either  charged  the  premiums  on  per- 
sonal policies  to  the  business  as  an  expense  or  capitalized  them  on 
the  books  of  the  business  as  an  asset.  This  is  a  matter  of  bad 
general  practice  rather  than  having  anything  to  do  specifically 
with  the  matter  of  insurance.  It  is  mentioned  here,  however,  be- 
cause of  the  fact  that  insurance  is  one  of  the  items  which  sole 
proprietors  seem  prone  to  mingle  with  their  business  accounts. 
There  has  been  a  custom  for  some  time  among  copartnerships 
and  corporations  to  insure  its  members  or  officers  for  the  benefit 
of  the  copartnership  or  corporation.  The  loss  of  a  partner  may 
be  very  keenly  felt  by  a  surviving  partner.  In  the  same  way  the 
loss  of  an  officer  or  important  employee  to  a  corporation  might 
prove  detrimental.  It  should  be  borne  in  mind  strictly  in  these 
cases  that  the  insurance  is  taken  out  by  the  concern  and  not  by  the 
individual,  and  that  the  concern  pays  the  premiums.  It  means, 
therefore,  that  the  concern  and  not  the  individual  should  either 
charge  to  expense  or  capitalize  the  insurance  premiums  paid. 
As  to  capitalization,  there  can  be  no  well-founded  objection  to  it 

217 


Principles  of  Accounting 

after  the  third  annual  premium,  except  in  the  case  of  straight  life, 
has  been  paid,  since  the  law  requires  that  such  policies  shall  have  a 
cash  surrender  value.  It  is,  therefore,  perfectly  proper  to  cap- 
italize the  premiums  at  their  cash  surrender  value. 

It  is  doubtful  if  the  accountant  would  ever  come  in  contact 
with  health  insurance  in  connection  with  the  affairs  of  a  business 
concern.  It  is  possible,  of  course,  to  imagine  a  case  in  which  a 
health  policy  would  be  carried  by  the  concern  on  account  of 
some  of  its  officers  or  employees.  This,  however,  is  not  apt  to  be 
the  case,  as  a  health  policy  is  usually  taken  out  by  an  individual 
in  his  own  behalf  in  order  that  he  may  be  reimbursed  for  loss  of 
salary  and  expenses  in  case  of  sickness. 

It  might  be  interesting  to  note  what  would  transpire  in  case 
of  the  death  of  an  employee  of  a  given  company.  To  do  this 
the  application  must  be  made,  of  course,  to  both  a  copartnership 
and  a  corporation,  since  in  each  case  the  situation  would  be 
slightly  different.  In  the  case  of  a  copartnership,  upon  receipt  of 
the  amount  of  the  policy  cash  would  be  charged  and  profit  and 
loss  credited.  Thus  the  surviving  partner  and  the  estate  of  the 
deceased  would  participate  to  the  extent  in  which  the  partners 
had  previously  been  interested  in  the  profits.  Since  the  object  of 
the  insurance  is  to  protect  the  surviving  partners  against  loss  of 
capital  through  the  sudden  withdrawal  by  reason  of  the  death  of 
a  partner,  it  sometimes  happens  that  the  policies  are  drawn  in 
favor  of  the  surviving  partners.  In  such  a  case  it  usually  hap- 
pens that  each  partner  is  equally  insured  for  the  benefit  of  the 
firm,  and  while  each  stands  his  share  of  loss  through  the  payment 
of  the  premium  he  takes  the  risk  of  failing  to  survive  his  partner. 
Where  this  situation  existed,  upon  receipt  of  the  cash  in  settle- 
ment of  the  policy  cash  would  be  charged  and  the  respective 
capital  accounts  of  the  surviving  partners  credited. 

While  contact  with  life  insurance  problems  on  the  part  of  the 
accountant  is  somewhat  rare,  fire  insurance  demands  his  attention 
in  practically  every  concern  with  which  he  comes  in  contact.  In 
practically  every  instance  it  is  the  question  of  premiums.  Occa- 
sionally it  is  in  connection  with  a  fire  loss.  Since  it  is  the  ques- 
tion of  premiums  that  most  frequently  concerns  him,  they  may 
perhaps  be  discussed  first. 

A  premium  is  paid  for  protection  covering  various  periods  up 
to  three  years.     The  author's  experience  leads  him  to  observe 

218 


Insurance 

that  while  formerly  the  three-year  period  was  a  popular  one 
such  policies  are  becoming  fairly  scarce  and  the  year  at  the 
present  time  seems  to  be  the  usual  period.  The  pertinent  fact 
in  connection  with  the  premium  is  that  it  covers  a  period  of  time. 
It  is,  therefore,  evident  that  the  premium,  which  is  to  be  treated 
as  an  expense,  should  be  spread  over  the  period  of  time  covered 
and  not  charged  to  expense  in  the  month  or  period  in  which  the 
premium  was  paid  or  the  expense  incurred.  It  will  thus  be  evi- 
dent that  insurance  covering  a  period  running  beyond  the  date 
upon  which  the  account  period  closes  may  be  considered  as  a  de- 
ferred charge  to  expense,  or,  as  it  has  sometimes  been  called,  an 
asset  by  courtesy.  The  problem  which  confronts  the  accountant 
is  that  of  determining  the  amount  of  the  unexpired  insurance.  It 
may  be  mentioned  here,  however,  that  the  necessity  for  this  cal- 
culation may  be  avoided  by  having  all  policies  lapse  on  the  same 
date,  which  practice,  in  case  the  date  coincides  with  the  end  of 
the  accounting  year,  will  give  rise  to  a  situation  in  which  there  is 
no  unexpired  insurance  involved.  Having  all  new  policies  written 
for  periods  ending  on  December  31,  for  example,  there  would  be 
no  unexpired  insurance  at  the  end  of  the  year.  This  will  not  be 
true,  of  course,  if  the  books  are  closed  on  June  30,  but  the  unex- 
pired insurance  at  such  time  will  be  one-half  the  annual  premium 
subject  to  slight  adjustment  perhaps  on  account  of  new  policies 
which  have  been  written  for  periods  less  than  a  year.  This 
scheme  has  been  advantageously  employed  in  a  number  of  cases 
which  have  come  under  the  writer's  observation,  and  much  figur- 
ing and  bookkeeping  has  thereby  been  avoided.  Notwithstanding 
the  fact  that  the  practice  is  a  good  one,  it  is  not  a  general 
one,  and  the  accountant  is  called  upon  to  value  the  unexpired 
insurance.  To  the  end  that  the  procedure  may  be  illustrated 
by  practical  application,  the  following  applied  theory  test  is 
suggested : 

London,  Liverpool  &  Globe,  No.  705,965,  Amount,  $10,000. 
Dated  June  17,  1912.     One  year.     Premium,  $56.27. 

North  British  and  Mercantile,  No.  714,837.  Amount, 
$6,000.  Dated  October  23,  1912.  One  year.  Pre- 
mium, $31.48. 

Scottish  Union  and  National,  No.  4,220,876.  Amount, 
$3,000.    July  14,  1912.    One  year.    Premium,  $18.26. 

219 


Principles  of  Accounting 

American  of  Newark,  No.   1,427,832.     Amount,  $7,000. 

Dated    February    22,    1912.      One   year.      Premium, 

$47.82. 
Aetna  Insurance,  No.  528,789.     Amount,  $5,000.     Dated 

February  28,  1912.     One  year.     Premium,  $322.13. 

Compute  the  unexpired  insurance  December  31,  191 2. 

It  is  probably  the  custom  in  computing  unexpired  insurance 
to  divide  the  annual  premium  by  365  or  366  days,  as  the  case 
may  be,  and  after  thus  ascertaining  the  rate  per  day  multiply  the 
said  rate  by  the  number  of  days  unexpired.  A  computation  of 
this  kind  is,  of  course,  accurate,  but  the  process  somewhat  labori- 
ous. In  cases  where  extreme  accuracy  is  not  necessary  it  suffices 
many  times  to  take  the  unexpired  period  as  so  many  twelfths  of 
a  year,  depending  upon  the  proximity  of  the  expiration  date  to 
the  end  of  the  month.  For  example:  A  policy  expiring  on  the 
third  of  May  would  be  treated  as  four-twelfths  expired. 

The  difficulty  involved  in  setting  up  unexpired  insurance  is 
sometimes  overcome  by  having  an  insurance  register.  This  is  a 
book  which  provides  for  the  name,  number,  amount,  date,  period 
and  premium  of  each  policy  and  has  twelve  columns,  correspond- 
ing to  the  months  of  the  year,  over  which  each  premium  is  dis- 
tributed. It  thus  becomes  an  easy  matter  to  determine  by  footing 
the  column  corresponding  to  a  given  month  what  the  charge  to 
expense  for  that  month  should  be.  When  the  insurance  regis- 
tered does  not  obtain,  the  method  of  treatment  in  closing  the 
books  will  be  to  charge  insurance  unexpired  and  credit  insurance. 
But  where  the  register  is  used,  the  procedure  will  be  the  reverse, 
namely:  having  charged  all  premiums  to  an  unexpired  insurance 
account,  in  closing  the  books  insurance  will  be  charged  and  un- 
expired insurance  credited  in  the  amount  shown  by  the  footing  of 
the  corresponding  month  in  the  insurance  register. 

An  important  question  arises  frequently  in  connection  with  un- 
expired insurance.  As  is  probably  known,  if  a  policy  is  canceled 
the  assured  will  not  receive  back  the  proportion  of  the  premium 
corresponding  to  the  unelapsed  time.  For  example :  If  a  policy 
on  which  the  premium  is  $60  per  year  is  canceled  on  the  30th  of 
September,  the  assured  will  not  receive  as  a  return  premium  $15, 
but  approximately  $12.75.  This  is  due  to  the  fact  that  the  fire 
insurance  companies  make  use  of  what  is  known  as  the  short 

220 


Insurance 

rate  basis.  It  is  considered  by  the  companies  that  it  costs  them 
more  to  carry  a  risk  for  a  short  time  than  a  longer  time.  There 
must  also  be  some  provision  for  the  expense  of  securing  the  busi- 
ness, such  as  the  agent's  commissions,  etc.  For  this  reason  the 
companies  make  use  of  a  short  rate  table  in  New  York.  For 
example,  such  as  is  prescribed  by  the  New  York  Fire  Insurance 
Exchange,  which  has  the  effect  of  reducing  the  value  of  the  un- 
expired insurance.  The  question  which  now  arises  is,  Shall  the 
unexpired  insurance  be  figured  on  the  basis  of  the  unexpired 
time  or  on  the  short  rate  basis?  The  argument  in  favor  of  the 
latter  is  that  the  amount  so  determined  would  be  all  that  could 
be  obtained  on  the  premium  were  it  to  be  canceled.  Against  this 
there  is  the  contention  that  it  is  not  expected  that  the  policy  will 
be  canceled  and  that,  therefore,  to  a  going  concern  the  premium 
has  its  full  value  and  it  may  be  with  propriety  pro-rated  over  the 
period  which  it  covers.  It  is,  therefore,  thought  that  a  logical 
answer  to  the  question  as  to  the  basis  upon  which  unexpired  in- 
surance should  be  computed  consists  in  saying  that  in  the  case 
of  a  going  concern  it  may  be  pro-rated,  whereas,  in  the  case  of 
a  concern  about  to  go  into  bankruptcy,  or  in  making  up  a  state- 
ment of  affairs,  unexpired  insurance  should  be  figured  on  the 
short  rate  basis. 

A  question  frequently  arises  with  regard  to  fire  losses  as  to 
the  relation  of  the  insured  to  the  company  and  the  rights  of  each 
party  to  the  contract.  The  settlement  of  a  fire  loss  will  depend 
usually  on  whether  or  not  the  policy  is  a  "valued"  one  and  whether 
or  not  the  property  is  insured  under  what  is  known  as  the  80 
per  cent,  clause.  Many  States  have  what  are  called  "valued  policy 
laws,"  under  which  the  insured  receives  the  amount  stated  in  his 
policy  in  case  of  a  total  loss.  There  is  an  exception  to  this  rule 
in  some  States  in  that  allowance  is  made  for  depreciation.  The 
person  insured  for  $10,000  and  having  a  total  loss  would  in  some 
States  receive  the  full  $10,000,  whereas  in  others  he  would  re- 
ceive $10,000  less  an  estimated  amount  for  depreciation.  The 
rates  of  valued  policies  are  naturally  higher  than  on  other  kinds. 
In  the  majority  of  cases  the  policy  stipulates  that: 

"This  company  shall  not  be  liable  beyond  the  actual  cash 
value  of  the  property  at  the  time  any  loss  or  damage  occurs, 
and  the  loss  or  damage  shall  be  ascertained  or  estimated  ac- 

221 


Principles  of  Accounting 

cording  to  such  actual  cash  value,  with  proper  deduction  for 
depreciation  however  caused,  and  shall  in  no  event  exceed 
what  it  would  then  cost  the  insured  to  repair  or  replace  the 
same  with  material  of  like  kind  and  quality ;  said  ascertainment 
or  estimate  shall  be  made  by  the  insured  and  this  company,  or, 
if  they  differ,  then  by  appraisers,  as  hereinbefore  provided; 
and,  the  amount  of  loss  or  damage  having  been  thus  deter- 
mined, the  sum  for  which  this  company  is  liable  pursuant  to 
this  policy  shall  be  payable  sixty  days  after  due  notice,  ascer- 
tainment, estimate  and  satisfactory  proof  of  the  loss  have  been 
received  by  this  company  in  accordance  with  the  terms  of  this 
policy.  It  shall  be  optional,  however,  with  this  company  to 
take  all,  or  any  part,  of  the  articles  at  such  ascertained  or 
appraised  value,  and  also  to  repair,  rebuild  or  replace  the 
property  loss  or  damage  with  other  of  like  kind  and  quality 
within  a  reasonable  time  on  giving  notice,  within  thirty  days 
after  the  receipt  of  the  proof  herein  required,  of  its  intention 
so  to  do;  but  there  can  be  no  abandonment  to  this  company 
of  the  property  described." 

There  would  appear  from  an  accounting  point  of  view  to  be 
some  contradiction  of  terms  in  the  above  paragraph.  For  ex- 
ample: "actual  cash  value,  with  proper  deductions  for  deprecia- 
tion." It  is  understood  that  by  this  is  meant  what  the  accountant 
looks  upon  as  book  value,  namely,  cost  less  depreciation.  It  will 
thus  be  seen  that  under  contracts  of  this  kind  the  insured  will, 
in  case  of  a  total  loss,  receive,  not  the  amount  stated  in  the  policy, 
but  an  amount  corresponding  to  the  value  of  the  property  de- 
stroyed. This  would  be  true  as  a  rule,  except  in  cases  where 
the  insured  becomes  a  co-insurer  under  the  80  per  cent,  clause. 
This  clause  requires  that  the  property  shall  be  insured  for  at  least 
80  per  cent,  of  its  value.  In  the  case  of  failure  to  do  this  the 
insured  becomes  proportionately  liable  for  the  loss  to  the  extent 
of  the  difference  between  what  the  property  is  insured  for  and 
80  per  cent,  of  its  value.  Assume,  for  example,  that  the  value 
of  a  certain  manufacturing  plant  is  $100,000;  that  the  insurance 
carried  thereon  is  $50,000;  that  the  loss  through  fire  is  fixed  at 
$40,000.  The  insured  will,  upon  settlement  in  such  a  case,  receive 
not  $40,000,  the  amount  of  the  loss,  but  $25,000,  or  five-eighths 
of  the  loss.    The  insured  will  have  become  a  co-insurer  with  the 

222 


Insurance 

company  to  the  extent  of  three-eighths  and  the  loss  will  be  borne 
by  the  company  and  the  insured  in  the  proportions  of  five-eighths 
and  three-eights  respectively. 

Much  discussion  has  occurred  in  accounting  circles  with  regard 
to  the  position  into  which  the  insured  puts  himself  by  providing 
for  depreciation  of  his  property  and  showing  same  on  his  books 
and  balance  sheets.  The  question  of  the  matter  of  insurance  has 
very  often  arisen  in  connection  with  the  manner  of  stating  the 
property  and  reserves  for  depreciation  accounts  on  the  balance 
sheet.  It  has  been  claimed  by  some  that  the  reason  for  showing 
the  reserves  broad  instead  of  deducting  them  from  the  asset  ac- 
counts  was  to  avoid  having  fixed  any  book  value  on  the  assets 
whereby  the  insured  could  be  bound  by  the  company  in  case  of 
a  fire  loss.  It  was  argued  that  writing  the  asset  down  and 
showing  it  net  on  the  balance  sheet,  or  showing  the  cost  and 
deducting  the  reserve  on  the  balance  sheet,  was  an  admission  of 
the  depreciation  value  of  the  property,  whereas  showing  the  asset 
at  its  cost  and  placing  the  reserve  on  the  liability  side  gave  the 
same  effect  to  the  proprietor's  net  worth,  at  the  same  time  the 
proprietor  did  not  admit  publicly  that  the  reserve  was  anything 
more  than  his  estimate  of  the  depreciation.  The  absurdity  of  this 
contention  will  be  apparent  from  the  following  quotation,  taken 
from  the  standard  form  of  policy : 

"The  insured,  as  often  as  required,  shall  exhibit  to  any 
person  designated  by  this  company  all  that  remains  of  any 
property  herein  described,  and  submit  to  examinations  under 
oath  by  any  person  named  by  this  company,  and  subscribe  the 
same ;  and,  as  often  as  required,  shall  produce  for  examination 
all  books  of  account,  bills,  invoices,  and  other  vouchers  or 
certified  copies  thereof  if  originals  are  lost,  at  such  reasonable 
place  as  may  be  designated  by  this  company  or  its  representa- 
tives, and  shall  permit  extracts  and  copies  thereof  to  be  made." 

It  would  appear  from  the  above  as  though  this  were  an  ex- 
cellent argument  as  to  why  proprietors  should  exercise  care  in 
computing  depreciation  and  should  proceed  with  such  computa- 
tions scientifically. 

The  treatment  of  fire  losses  in  the  accounts  presents  an  inter- 
esting topic  for  discussion.  As  to  the  procedure,  it  may  be  said 
that  there  are  two  forms.     The  first  and  more  logical  one,  since  it 

223 


Principles  of  Accounting 

follows  the  facts  historically,  would  consist  in  relieving  the 
property  account  and  charging  the  company  at  the  time  the  loss 
is  determined.  The  other  consists  in  deferring  any  entry  until 
such  time  as  the  cash  is  received,  when  the  property  ac- 
count is  relieved.  The  principle  is  the  same  in  either  case, 
regardless  of  whether  the  policy  is  a  valued  one  or  the 
property  is  or  is  not  insured  under  the  80  per  cent,  clause. 
The  only  difference  in  any  of  these  variations  would  be  the 
extent  of  the  loss.  Assume,  for  example,  the  cost  of  a 
certain  piece  of  property  to  be  $100,000;  reserves  having  been 
set  up  to  the  extent  of  $20,000 ;  a  fire  occurs  and  the  loss  is  fixed 
at  $60,000.  Under  the  first  procedure  the  reserve  will  first  be 
closed  out  against  the  asset  account,  making  the  balance  $80,000. 
The  company  will  then  be  charged  on  the  books  with  $60,000, 
profit  and  loss  will  be  charged  with  $20,000,  and  the  property 
account  will  be  credited  with  $80,000,  thereby  closing  it  out.  At 
the  time  the  settlement  is  actually  made  cash  will  be  charged  with 
$60,000  and  the  company  credited.  This  procedure  shows  all  the 
steps  in  the  transactions  and  is  to  be  preferred.  The  second  form 
of  procedure  consists  in  deferring  the  entries  until  such  time  as 
the  settlement  is  made,  when  the  reserve  will  first  be  closed  out 
to  the  property  account,  leaving  a  balance  of  $80,000,  while  cash 
will  be  charged  in  the  amount  of  $60,000,  profit  and  loss  in  the 
amount  of  $20,000,  and  the  property  credited  with  the  amount  of 
$80,000.  In  so  far  as  profit  and  loss  is  concerned  the  reverse  of 
the  above  would  be  true  if  the  amount  of  the  loss  were  fixed  at 
a  figure  higher  than  the  book  value  of  the  property.  The  entries, 
as  outlined  above,  would  operate  on  the  same  principles  in  the 
case  of  other  forms  of  insurance,  such  as  marine,  burglary  and 
fidelity.  In  all  cases  the  property  lost  would  be  replaced  by  the 
amount  recovered  from  the  insurance  company  and  the  difference 
debited  or  credited  to  profit  and  loss  in  accordance  with  the  rela- 
tion which  the  settlement  bore  to  the  book  value  of  the  property. 
Credit  insurance  works  out  practically  the  same  way.  The  com- 
pany bases  its  risk  on  the  ratio  of  sales  to  losses  of  the  insured  in 
past  years.  In  the  case  of  loss  the  amount  received  from  the 
company  takes  the  place  of  that  which  was  not  received  from  the 
debtor,  and  the  difference  is  charged  to  profit  and  loss.  A  well 
organized  and  efficient  credit  department  is  very  often  cheaper 
than  credit  insurance. 

224 


Insurance 

Employer's  liability  insurance  is  somewhat  different  from  any 
of  the  above  mentioned.  On  May  30,  1908,  the  President  of 
the  United  States  approved  an  act  of  Congress  "granting  to  cer- 
tain employees  of  the  United  States  the  right  to  receive  from  it 
compensation  for  injuries  sustained  in  the  course  of  their  employ- 
ment." Similar  laws  have  been  passed  by  various  States,  among 
the  most  prominent  of  which  are  Massachusetts  and  New  York. 
Thus  it  will  be  seen  that  business  concerns  in  the  various  States 
where  these  laws  exist  have  become  liable  for  damages  for  in- 
juries sustained  by  employees  in  the  pursuit  of  their  work.  A 
very  natural  consequence  of  these  laws  was  the  springing  up  of 
employers'  liability  insurance  companies  to  take  the  place  of  and 
relieve  employers  from  the  obligation  of  having  to  settle  with 
employees  in  cases  of  accident.  When  an  accident  occurs  the 
employer  turns  the  case  over  immediately  to  the  insurance  com- 
pany, which  either  makes  an  immediate  settlement  with  the  injured 
workman  or  defends  the  suit  in  case  litigation  ensues.  For  this 
reason  the  insurance  company  charges  a  premium  which,  pre- 
sumably for  the  want  of  a  better  or  more  logical  basis,  is  com- 
puted on  the  amount  of  the  yearly  payroll.  Since  the  amount  for 
the  current  year  cannot  be  determined  in  advance,  it  is  the  custom 
in  computing  the  premium  to  base  it  on  the  payroll  of  the  previous 
year.  The  premium  is  then  paid.  At  the  end  of  the  year  a  report 
is  made  to  the  company,  showing  the  exact  amount  of  the  premium 
for  the  current  year  and  the  correct  premium  is  then  computed, 
the  difference  between  the  previous  premium  and  the  correct  one 
being  adjusted  either  by  a  payment  to  or  rebate  by  the  insurance 
company.  Here  the  matter  of  adjustments  of  asset  accounts  does 
not  enter  in.  There  is  nothing  actually  lost  and  there  is  nothing 
to  be  replaced,  for  the  reason  that  no  settlement  is  made  by  the 
company  to  the  insured.  All  that  the  company  does  is  to  relieve 
the  insured  of  the  risk  of  having  to  stand  damage  suits,  and  for 
this  insurance  the  insured  pays  a  premium  which  is  charged  to 
expense.  It  should  be  noted  that  in  this  case,  as  well  as  other 
forms  of  insurance  above  mentioned,  where  premiums  are  paid 
in  advance,  it  is  perfectly  proper  to  set  up  the  proportion  cor- 
responding to  the  unexpired  time  when  the  books  are  closed. 


225 


CHAPTER   XXXIV 

TAXES 

A  tax  may  be  considered  as  a  contribution  imposed  by  the 
government  upon  its  citizens  for  its  support.  In  exchange,  the 
government  extends  its  protection  to  the  Hfe  and  property  of 
citizens  through  its  various  police  organizations.  A  tax  is  some- 
what different  from  an  assessment.  An  assessment  is  something 
which  is  levied  but  once,  usually  for  the  purpose  of  some  local 
improvement.     A  tax  recurs  from  year  to  year. 

Taxes  may  be  divided  into  various  classes,  such  as  federal, 
State,  county,  municipal,  etc.  The  federal  government  imposes 
a  capital  stock  tax  and  an  income  and  profits  tax  on  corporations. 
There  is  also  an  income  tax  on  individuals,  co-partnerships  and 
other  forms  of  business  enterprise.  Federal  tax  legislation  gives 
rise  to  changes  in  the  law  so  frequently  that  it  is  impossible  to 
discuss  satisfactorily  the  accounting  thereunder  except  in  special 
treatises  which  are  revised  from  year  to  year.  It  must  suffice 
herein  to  say  that  no  accounting  is  complete  which  fails  to  take 
into  consideration  the  liability  for  federal  taxes,  even  though 
entries  are  based  on  estimates.  For  guidance  in  federal  tax 
matters  reference  should  be  had  to  Montgomery's  Income  and 
Profits  Tax  Procedure  and  Regulations  45  of  the  United  States 
Treasury  Department. 

Taxes,  other  than  federal,  vary  so  greatly  in  different  locali- 
ties that  it  is  likewise  impossible  to  cover  the  subject  adequately 
in  a  general  discussion.  The  accountant  should  acquaint  himself 
with  the  tax  laws  affecting  the  organization  whose  accounts  are 
under  consideration,  and  apply  the  principles  relating  to  taxes  in 
accordance  with  the  conditions  existing. 

In  New  York  City  there  is  a  tax  on  personal  property  im- 
posed on  corporations,  as  well  as  a  tax  on  real  estate.  In 
order  that  a  clearer  conception  of  real  estate  taxes  may  be 
had  it  will  probably  be  of  interest  to  run  through  the  pro- 
cedure for  computing  the  tax  as  it  exists  in  the  city  of  New  York. 
An  authority  on  the -subject  has  very  aptly  said  that  "the  city's 
money  is  spent  before  it  gets  it  and  that  this  fact  effects  the 
financial  situation  and  real  estate  taxation  to  some  degree."  The 
budget  of  appropriations  for  an  ensuing  year  is  made  in  the  fall. 

226 


Taxes 

The  budget  is  based  on  the  estimate  made  by  the  various  city 
departments  and  is  presented  to  the  Board  of  Estimate  and  Ap- 
portionment. As  approved  by  this  board  the  budget  becomes 
effective,  and  with  the  beginning  of  the  new  year  the  various 
departments  begin  their  disbursements  in  accordance  therewith. 
Asessments  of  property  having  been  made  during  the  preceding 
year,  on  October  15  the  tax  department  opens  its  books  on  the 
assessed  values  of  real  and  personal  property.  These  books, 
which  are  subject  to  inspection  and  corrections  by  the  affected 
parties,  remain  open  until  November  15,  although  hearings  of 
complaints  are  heard  until  the  first  of  February,  when  the  books 
are  closed  and  the  assessment  rolls  are  made  up.  On  the  first 
of  March  the  assessment  rolls  are  sent  to  the  Board  of  Aldermen, 
which  fixes  the  tax  rate,  taking  into  consideration  the  budget, 
the  estimated  revenues  reported  by  the  comptroller  and  the  total 
assessed  value  of  real  and  personal  property  subject  to  general 
taxation.  As  an  illustration  of  the  manner  in  which  the  tax  rate 
is  fixed  the  figures  for  the  year  1912  may  be  used: 

Assessed  values : 

Real  property $7,861,898,890.00 

Personal  property 342,963,540.00        $8,204,862,430.00 

Appropriations : 

City $170,873,102.43 

County 10,604,762.66  $181,477,865.09 

Less  estimated  revenues 30,971,807.62 

Amount  to  be  raised $150,506,057.41 

Deducting  $30,971,807.62  from  $181,477,865.09  will  give  the 
amount  to  be  raised  by  general  tax.  By  dividing  $150,506,057.47 
by  $8,204,862,430  it  will  be  seen  that  the  ratio  of  the  former  to 
the  latter  is  .0183  plus,  or  1.83  plus  per  cent.  This  rate,  while 
being  the  average  for  the  entire  city,  fluctuates  as  among  counties, 
varying  from  1.83  per  cent,  in  New  York  County  to  1.92  per 
cent,  in  Richmond  County.  Taxes  are  now  (1922)  due  and 
payable  in  the  city  of  New  York  in  two  instalments,  the  first 
half  on  May  i,  the  second  half  on  November  i.  If  the  first  half 
is  paid  in  May  interest  is  allowed  on  the  amount  from  May  i  to 

22y 


Principles  of  Accounting 

November  i.  If  not  paid,  interest  is  charged  for  the  same  period. 
In  the  month  of  November  taxes  are  payable  without  interest, 
except  as  to  the  adjustment  necessary  to  provide  for  the  first 
half,  while,  on  the  first  of  December,  a  penalty  of  i  per  cent,  is 
added,  and  on  the  15th  of  January  interest  begins  to  run  at  the 
rate  of  7  per  cent. 

"Whenever  any  tax  or  assessment  shall  remain  unpaid  for 
three  years  or  any  water  rent  shall  remain  unpaid  for  four 
years  the  tax  lien  on  the  property  will  be  sold  to  satisfy  such 
arrears  of  taxes,  assessments  or  water  rents,  and  all  taxes, 
assessments  and  water  rents  up  to  a  day  to  be  named  in  the 
advertisement  of  sale  as  stated  therein." 

An  important  point  in  connection  with  taxes  is  the  accrual  and 
treatment  of  taxes  paid  in  advance.  The  accruing  of  the  taxes 
will  depend  very  largely  on  the  fiscal  period  and  the  date  at  which 
the  books  are  closed.  Concerns  which  close  their  books  monthly 
find  it  necessary  to  accrue  from  month  to  month  if  the  taxes  are 
of  sufficient  size  and  importance  to  warrant  this  treatment.  In 
this  way  the  proper  charge  is  made  to  the  expense  accounts  for 
the  month  and  the  proper  liability  accumulated  through  the  accrual 
account.  This  stands  until  sucn  time  as  the  taxes  for  the  year 
are  paid.  The  accrual  account  is  then  (in  New  York  State) 
automatically  converted  into  a  prepaid  account,  since  the  taxes 
will  have  been  paid  for  the  entire  year.  For  the  purpose  of 
making  this  clear  the  following  illustration  will  serve : 

Assuming  the  assessed  value  of  a  piece  of  property  in  New 
York  County  to  be  $100,000  and  the  tax  rate  for  the  year  1912 
1.83  per  cent.,  the  tax  for  the  year  will  be  $1,830,  or  $152.50  per 
month.  If  the  books  were  closed  monthly  or,  at  least,  if  monthly 
statements  of  income  and  profit  and  loss  were  prepared,  then  the 
entry  to  be  made  each  month  would  be  as  follows : 

Taxes $152.50 

To  Taxes  accrued $152.50 

This  entry  would  be  repeated  each  month  and  the  charge  to 
taxes  would  be  closed  out  monthly  to  profit  and  loss.  The  taxes 
accrued  account  would  accumulate  so  that  at  the  end  of  the  first 

228 


Taxes 

six  months,  or  at  June  30,  the  account  would  show  $915.  If  the 
tax  bill  for  the  first  six  months  is  now  paid,  taxes  accrued  will  be 
charged  and  cash  credited  in  the  amount  of  $915.  A  further 
complication  may,  however,  in  practice  take  place  in  connection 
with  the  taxes  for  the  first  six  months  as  well  as  those  for  the 
year.  Tax  bills  are  not  sent  out  by  the  city.  It  is  necessary  to 
request  them  from  the  receiver  of  taxes.  Assuming  now  that  the 
request  for  a  tax  bill  for  the  first  six  months  of  the  year  has  been 
made  prior  to  May  I,  and,  as  a  matter  of  fixing  the  date,  has 
been  received  on  April  23,  at  the  end  of  April  the  taxes  accrued 
will  amount  to  $610,  but  the  tax  bill  will  amount  to  $915.  This 
means  that  the  bill  includes  not  only  the  first  four  months  but 
also  the  months  of  May  and  June.  The  question  which  now 
arises  is  the  treatment  of  the  tax  bill.  One  method  of  treatment 
would  be  to  charge  taxes  accrued  and  credit  cash  with  $915. 
This  will  convert  the  taxes  accrued  account  automatically  into  a 
prepaid  taxes  account  and  the  prepayment  will  be  in  the  amount  of 
$305.  The  more  scientific  manner  of  treating  the  matter  would 
be  to  charge  taxes  paid  in  advance  and  credit  taxes  accrued  with 
$305  and  subsequently  charge  taxes  accrued  and  credit  cash  with 
$915  when  the  payment  is  made.  The  amount  of  $305  in  the 
taxes  prepaid  account  will  be  disposed  of  in  the  months  of  May 
and  June  by  charging  taxes  in  the  respective  months  and  credit- 
ing taxes  paid  in  advance.  The  second  six  months  would  not 
differ  in  any  respect  from  the  first  six  months  except  that  in 
case  payment  of  the  first  six  months  had  not  been  made  when  due. 
Under  such  circumstances  the  principle  involved  would  be  the 
same,  but  the  amounts  would  change.  The  charge  to  the  taxes 
account  would  be  made  regularly  from  month  to  month,  but  the 
taxes  accrued  account  would  increase  gradually  in  accordance 
therewith.  If  the  tax  bill  is  paid  before  the  end  of  the  year  there 
will  be  an  unexpired  portion  to  be  taken  care  of.  If  not  paid 
until  after  the  end  of  the  year  this,  of  course,  will  not  be  true. 

The  question  of  interest  is  one  which  sometimes  causes  discus- 
sion. The  question  is  whether  interest  on  taxes  should  be  charged 
to  the  interest  account  or  to  the  account  for  taxes.  If  the  matter 
is  to  be  scientifically  treated  it  is  probable  that  the  interest  should 
be  charged  to  the  interest  account,  since  the  concern  under  dis- 
cussion has  in  eflfect  a  contract  as  to  the  dates  upon  which  pay- 
ments are  to  be  made.    If  payments  are  not  made  and  the  tax- 

229 


Principles  of  Accounting 

payer  has  the  use  of  the  money  he  pays  therefor  interest.  If 
the  capitaHstic  theory  is  to  be  consistently  maintained,  interest  on 
taxes  will  have  to  be  charged  to  interest.  It  is  very  probable, 
however,  that  in  the  majority  of  cases  interest  will  be,  even 
though  erroneously,  added  to  the  taxes  paid. 

In  some  States  taxes  are  payable  for  the  year  in  advance.  In 
such  cases  the  treatment  of  the  taxes  becomes  analogous  with  that 
of  interest  paid  in  advance.  The  taxes  are  set  up  in  a  prepaid 
account  and  charged  out  to  the  expense  account  as  time  passes. 

It  will  be  noted  in  many  published  balance  sheets,  and  most 
especially  in  the  case  of  banks,  that  the  taxes  are  shown  on  the 
liability  side  under  a  caption  called  reserve  for  taxes.  This  would 
appear  to  be  merely  a  loose  manner  of  expressing  the  situation, 
since,  as  a  rule,  a  reserve  has  not  been  created  for  taxes  any  more 
than  for  any  other  current  liability.  It  would  seem  that  this 
item  might  with  most  propriety  be  called  taxes  accrued.  There 
would  be  no  objection  and  perhaps  in  certain  instances  it  might 
be  desirable  to  make  a  distinction  between  the  taxes  accrued  and 
due  and  those  accrued  and  not  due.  Difficulty  is  also  encountered 
at  times  in  ascertaining  the  proper  amount  of  taxes  for  the  year. 
This  is  before  the  tax  rate  is  ascertained  and  before  the  tax  bills 
can  be  obtained.  It  is  customary  in  such  cases  to  use  the  rate 
and  assessed  value  for  the  preceding  year.  This,  of  course,  is  in 
effect  an  estimated  amount,  and  it  may  reasonably  happen  that 
the  correct  amount  for  the  year  when  ascertained  will  disagree 
with  the  estimated  amount.  The  proper  method  of  treatment  is 
to  proceed  with  the  monthly  charge  to  taxes  and  credit  to  taxes 
accrued  on  the  estimated  basis  until  such  time  as  the  correct 
amount  has  been  ascertained,  when  the  charge  should  be  revised 
and  the  adjustment  necessary  to  put  the  account  on  the  proper 
basis  be  made.  Thus,  it  might  happen  that  in  the  case  of  a  given 
concern  the  amount  of  taxes  estimated  for  the  year  might  be 
$1,500.  Such  an  amount  would  mean  $125  a  month.  If  the 
charge  for  taxes  were  made  monthly,  then  at  the  end  of  the  month 
of  April  there  would  have  been  charged  to  taxes  and  credited  to 
taxes  accrued  $500.  If  now  the  tax  bill  for  the  year  is  obtained 
and  it  is  found  that  the  taxes  for  the  year  will  amount  to  $1,830, 
then  it  is  apparent  that  instead  of  having  charged  $500,  $610 
should  have  been  charged.  It  will  then  be  necessary  to  make  a 
supplementary  charge  for  the  four  months  of  $1 10,  the  difference 

230 


Taxes 

between  $500  and  $610,  or  the  difference  per  month  between  $125 
and  $152.50.  If,  perchance,  the  estimate  will  in  any  case  have 
been  too  high,  the  adjustment  necessary  must  be  the  reverse  of 
the  one  just  described.  As  a  practical  matter,  however,  this  is 
not  liable  to  occur,  since  taxes  are  inclined  to  increase  rather  than 
to  decrease. 


231 


CHAPTER   XXXV 

MISCELLANEOUS    PROFITS   AND    LOSSES 

In  every  business  there  are  necessarily  profits  more  or  less 
uncommon  which  are  not  directly  connected  with  the  particular 
line  of  business  in  which  the  organization  is  engaged.  For 
example:  Sales  of  land  or  buildings,  machinery  or  tools,  horses, 
wagons,  harness,  furniture  or  fixtures,  materials  and  supplies, 
scrap,  etc.  Such  transactions  are  incidental  and  are  not  con- 
templated in  the  scheme  of  business  for  the  realization  of  profit. 
That  there  are  profits  in  connection  with  such  sales,  as  well  as 
losses,  may  not  be  ignored.  They  are  irregular  and  intermittent 
and  may  not  be  depended  upon  to  produce  income.  Only  such 
items  should  be  considered  as  income  as  recur  regularly.  Such 
is  the  distinction  to  be  made  between  profits  and  income.  The 
assets  above  enumerated  are  normally  held  for  the  purposes  of 
the  business.  If  sold  at  a  figure  either  above  or  below  their  cost 
a  profit  or  loss  results.  Such  profits  should  be  classified  as  mis- 
cellaneous. This  group  should  also  include,  providing  such  items 
are  considered  as  profits,  appreciation  of  land  and  appreciation 
of  securities.  With  regard  to  such  treatment  of  these  items,  it 
may  be  said  that  the  best  practice  does  not  countenance  appre- 
ciation as  being  considered  a  profit.  Profits,  strictly  speaking, 
do  not  arise  until  a  sale  has  taken  place.  If  it  is  desired  to  show 
such  assets  as  land,  securities  or  materials  and  supplies  at  their 
market  price,  it  would  be  very  much  better  to  credit  the  increase 
to  a  reserve  instead  of  considering  such  increase  as  a  profit.  The 
practice  of  so  treating  a  theoretical  increase  in  value  is  responsible 
for  the  well-known  expression  "anticipating  profits."  Such  prac- 
tice has  nothing  in  its  favor  and  everything  to  condemn  it.  The 
items  are  merely  mentioned  here  on  account  of  the  tendency  of 
many  concerns  to  anticipate  profits  and,  while  contrary  to  good 
practice,  place  the  items  in  a  definite  class  in  case  they  are  so 
treated. 

For  the  purpose  of  general  classification  there  has  been  in- 
cluded among  miscellaneous  profits  amounts  previously  written 
off — now  collected.  This  is  satisfactory  so  far  as  general  classi- 
fication is  concerned,  but  if  the  refinements  are  to  be  entered  into, 

232 


Miscellaneous  Promts  and  Losses 

the  item  should  be  distinguished  from  the  other  items  in  this 
group  and  preferably  treated  as  an  addition  to  surplus  rather  than 
a  miscellaneous  profit.  This  item  illustrates  very  well  the  dis- 
tinguishing line  between  profits  and  surplus.  Profits  should  cover 
only  items  having  to  do  with  the  present  period.  The  recovery 
of  an  item  previously  written  off  takes  us  naturally  to  surplus, 
since  it  must  mean  that  the  writing  off  had  taken  place  in  a 
previous  period  and  the  surplus,  therefore,  correspondingly  de- 
creased. If  such  a  loss  has  been  charged  to  a  previous  period  and 
the  loss  is  now  wholly  or  partially  recovered,  credit  for  same 
should  not  be  given  to  the  present  period  but  to  the  previous 
period.  Since  the  nominal  accounts  for  the  previous  period  have 
been  closed,  there  remains  only  surplus.  Surplus  should,  there- 
fore, be  credited. 

It  sometimes  happens  that  where  an  accounting  period  is  a 
lengthy  one,  possibly  a  year,  there  will  have  been  written  oflf 
during  the  early  part  of  the  year  certain  bad  or  doubtful  accounts. 
It  may  subsequently  happen  that  within  the  same  year  a  collection 
will  be  made  on  some  of  the  supposedly  bad  accounts.  In  case 
of  such  occurrence  the  credit  for  the  recovery  should  be  made  to 
profit  and  loss,  or  to  the  account  for  bad  and  doubtful  accounts 
written  oflF,  instead  of  to  surplus. 

In  closing  the  books  the  procedure  will  depend  entirely  upon 
whether  separate  accounts  have  been  opened  for  the  respective 
miscellaneous  profits  or  whether  such  items  have  been  carried 
direct  to  profit  and  loss.  The  latter  is  probably  the  most  usual 
method  of  treatment.  If  separate  accounts  have  been  raised,  how- 
ever, they  should  be  closed  out  to  miscellaneous  profits,  which 
accounts  would  correspond  to  the  seventh  section  of  the  statement 
of  income  and  profit  and  loss,  namely:  profit  and  loss  credits. 
What  usually  happens  with  these  items  is  that  either  at  the  time 
the  sales  took  place  or  when  the  books  are  closed  the  credits  were 
made  direct  to  the  profit  and  loss  account.  In  preparing  the 
statement  it,  therefore,  becomes  necessary  to  analyze  the  credit 
side  of  the  profit  and  loss  account  in  order  that  comprehensive 
details  may  be  set  forth  in  the  statement. 

Miscellaneous  losses  comprise  not  only  the  complementary  side 
of  transactions  enumerated  above,  such  as  sales  of  land,  buildings, 
etc.,  but  also  provision  for  doubtful  accounts,  depreciation  of 

233 


Principles  of  Accounting 

buildings  and  miscellaneous  items,  such  as  amortization  of  patents, 
trademarks  or  good-will  and  organization  expense  written  off. 

With  regard  to  doubtful  accounts,  some  distinction  should  be 
made  between  the  provision  for  doubtful  accounts  and  doubtful 
or  bad  accounts  written  off.  Provision  for  doubtful  accounts 
anticipates  a  loss  through  such  causes  and  provides  for  it  in 
advance.  In  making  such  provision  it  is  customary  to  base  it  on 
a  sales  charge  concurrent  with  the  charges  to  accounts  receivable. 
Varying  rates,  ranging  from  2  to  5  per  cent,  or  even  higher, 
depending  upon  the  experience  of  the  organization  in  past  years, 
are  used.  The  charge  to  profit  and  loss  is  offset  by  a  credit  to  a 
reserve  for  doubtful  acounts.  This  has  the  effect  of  providing 
within  a  given  period  for  losses  which  may  occur  on  accounts 
receivable  raised  in  connection  with  sales  made  during  the  same 
period.  Good  practice  advocates  the  making  of  this  charge 
monthly  as  sales  are  made.  If  losses  are  subsequently  sustained 
they  are  charged  to  the  reserve  and  not  to  profit  and  loss,  for  the 
reason  that  provision  for  them  has  already  been  made  through 
a  preceding  charge.  If  ultimately  there  remains  in  the  reserve 
an  amount  corresponding  to  the  provision  that  was  not  required, 
this  amount  may  be  closed  out  to  surplus  and  not  to  profit  and  loss. 

It  will  thus  be  seen  that  there  is  a  considerable  difference 
between  providing  for  doubtful  accounts  and  writing  off  accounts 
which  ultimately  prove  bad.  Where  the  latter  method  is  used 
care  should  be  exercised  to  determine  whether  the  loss  is  on  sales 
which  have  taken  place  during  the  current  or  during  a  preceding 
period.  For  losses  on  sales  during  the  current  period,  profit  and 
loss  may  be  charged.  For  losses  on  sales  in  prior  periods  surplus 
should  be  charged.  The  reason  in  the  latter  case  is  that  the 
profits  of  the  preceding  period  and,  consequently,  surplus  receive 
credit  for  a  sale  which  in  a  succeeding  period  proved  to  be  bad 
and  resulted  in  a  loss.  Concerning  amortization  of  patents,  trade- 
marks or  good-will,  organization  expense  written  off,  it  may  be 
said  that  there  are  two  methods  of  treatment  available  for  use. 
The  assets  may  thus  be  written  down,  in  which  case  profit  and 
loss  will  be  charged  and  the  assets  credited,  or  their  value  may 
be  reduced  by  the  creation  of  a  reserve.  In  the  latter  case  profit 
and  loss  will  be  charged  and  the  reserve  credited. 

The  remarks  with  regard  to  the  closing  of  the  profit  accounts 
apply  with  equal  force  to  miscellaneous  losses.    It  is  not  probable 

234 


Miscellaneous  Profits  and  Losses 

that  separate  accounts  for  the  respective  losses  will  be  raised.  If 
they  are  raised,  they  should  be  closed  out  to  an  account  for  mis- 
cellaneous losses  or  to  profit  and  loss.  It  will  usually  happen, 
however,  that  these  losses  will  have  been  charged  direct  to  profit 
and  loss  and  that  it  will  be  necessary  in  preparing  the  statement 
of  income  and  profit  and  loss  to  analyze  this  side  of  the  profit  and 
loss  account  in  order  that  the  details  of  losses  may  be  set  forth 
in  the  section  of  the  statement  of  income  called  profit  and  loss 
charges. 

It  will  no  doubt  have  been  observed  that  dividends  payable 
have  not  been  included  in  the  classification  presented.  While  they 
may  be  appropriately  discussed  at  this  point,  they  are  not  to  be 
looked  upon  as  an  item  of  expense.  They  are  rather  to  be  con- 
sidered as  a  distribution  of  profits.  Profits  or  losses  in  the  case 
of  a  sole  proprietor  or  copartnership  will  be  disclosed  by  the 
profit  and  loss  account  and  will  be  closed  out  to  proprietorship; 
in  accordance  with  the  division  agreed  upon  in  the  contract,  in 
the  case  of  copartnership.  In  corporations  profits  may  be  dis- 
tributed by  vote  of  the  directors  from  the  surplus  arising  from 
the  business.  Technically  profits  are  closed  into  the  surplus 
account  and  the  surplus  distributed  as  dividends.  After  the  action 
of  the  directors  in  declaring  a  dividend  the  proper  entry  consists 
in  debiting  "dividends  declared"  or  surplus  and  crediting  "divi- 
dends payable."  If  the  account  "dividends  declared"  has  first 
been  charged,  it  will  be  closed  out  to  surplus.  Dividends  declared 
becomes  the  nominal  account  while  the  liability  is  taken  up  in  the 
dividends  payable  account.  When  the  liability  is  liquidated  by 
the  payment  of  cash,  dividends  payable  is  charged  and  cash 
credited.  Some  concerns  do  not  raise  the  account  for  dividends 
payable,  waiting  until  the  payment  is  made  before  charging  the 
nominal  account.  This  is  not  thought  to  be  the  best  practice, 
since  it  fails  to  show  the  history  of  the  dividend  transactions  and 
may  result  in  neglecting  to  show  a  liability  for  dividends  declared 
at  closing  time,  which  neglect  has  the  efifect  not  only  of  failing 
to  show  this  important  point  but  to  show  an  augmented  surplus. 


235 


CHAPTER   XXXVI 

ACCRUALS  AND  CLOSING  ENTRIES 

Accruals  are  necessary  in  accounting  if  true  financial  condi- 
tion and  correct  operations  are  to  be  shown.  Some  concerns  run 
their  books  and  prepare  their  statements  entirely  in  accordance 
with  the  cash  transactions.  Operations  are  controlled  by  the 
receipt  and  disbursement  of  cash.  Thus  we  hear  of  books  kept 
and  statements  prepared  on  a  cash  basis.  Scarcely  anything  could 
be  further  from  the  truth  in  so  far  as  condition  and  operations 
are  concerned.  Some  business  men  will  insist  that  they  are  not 
sure  of  any  profits  until  they  have  them  in  cash.  With  some, 
cash  seems  to  be  a  mania.  They  refuse  to  recognize  the  fact  that 
their  financial  condition  is  the  matter  of  importance  and  that 
financial  condition  is  represented  by  both  assets  and  liabilities. 
They  refuse  to  recognize  the  fact  that  cash  is  only  one  of  the 
items  which  make  up  the  assets.  The  man  who  contends  that 
he  has  nothing  except  that  he  has  it  in  cash  cannot,  it  seems, 
consistently  admit  that  he  owes  anything,  yet  there  is  never  very 
much  difficulty  in  drawing  out  this  admission.  Time  is  the 
medium  which  measures  the  majority  of  business  transactions, 
and  it  is  the  relation  of  these  transactions  to  the  time  which  has 
elapsed,  or  is  to  elapse,  that  must  be  taken  into  consideration  in 
scientific  accounting.  Most  accounts  seem  to  have  certain  loose 
ends  which  must  be  gathered  up  before  the  books  can  be  closed. 
To  do  this  consistently  the  accountant  or  bookkeeper  should  go 
through  the  accounts  one  by  one,  scrutinizing  and  studying  each 
carefully,  in  order  to  determine  whether  there  is  anything  about 
it  which  requires  treatment  in  order  that  it  shall  show  true  con- 
dition and  correct  operations.  Taking  up  the  items  in  the  order 
that  they  will  usually  appear  in  the  ledger,  they  may  require 
treatment  in  closing  as  follows: 

Land  may  have  increased  in  value  and  it  may  be  desired  by 
the  proprietor  that  it  be  shown  at  the  increased  value  in  the 
books.  There  is,  of  course,  a  natural  objection  on  the  part  of 
the  accountant  to  writing  up  land  and  taking  the  increment  into 
profits.  Conservatism  dictates  that  wherever  it  is  necessary  or 
desirable  to  increase  the  figure  at  which  land  is  carried  that  the 

236 


Accruals  and  Closing  Entries 

increase  shall  be  offset  by  a  reserve.  This  will,  of  course,  call 
for  an  entry  charging  land  and  crediting  reserve  for  appreciation 
of  land. 

Buildings  will  be  subject  to  depreciation,  which,  in  closing  the 
books,  must  be  taken  into  consideration.  The  same  statement 
will  apply  with  equal  force  to  equipment,  furniture  and  fixtures, 
horses,  wagons  and  harness,  motor  trucks,  etc.  The  depreciation 
may  be  handled  in  one  of  two  ways :  either  by  writing  down  the 
asset  through  a  charge  to  profit  and  loss  and  a  credit  to  the  asset, 
or  making  the  charge  to  profit  and  loss,  or  an  account  called 
provision  for  depreciation,  and  crediting  a  reserve  for  deprecia- 
tion. The  latter  method  is  to  be  preferred,  since  it  leaves  the  asset 
account  unaffected  by  depreciation  and  permits  it  to  show  bona 
fide  additions  and  deductions,  while  the  value  of  the  asset  is  cor- 
rectly shown  on  the  balance  sheet  through  the  offset  in  the  form 
of  a  reserve. 

Investments  may  fluctuate  in  value  and,  consequently,  it  may 
be  desirable  to  adjust  their  book  value  in  closing.  The  rule 
regarding  investments  is  that  they  shall  be  shown  at  cost.  In  the 
case  of  securities  the  rule  has  usually  been  to  show  them  at  cost 
if  cost  is  lower  than  the  market,  but  if  cost  is  higher  than  the 
market  to  reduce  them  to  the  market.  It  is  not  thought  advisable 
to  adjust  the  account  in  the  books  to  keep  pace  with  fluctuations 
in  market  values,  but  the  effect  is  secured  by  raising  the 
proper  reserves.  Not  alone  securities,  but  any  investments  which 
fluctuate  in  value,  may  be  adjusted  by  means  of  reserves.  If  the 
investment  has  increased  in  value,  an  entry  may  be  made  charging 
the  asset  account  and  crediting  a  reserve  for  appreciation  of  in- 
vestments. If  the  investment  has  decreased,  profit  and  loss  may 
be  charged  and  a  reserve  credited,  which  may  be  called  reserve 
for  depreciation  of  investments. 

Materials  and  supplies,  goods  in  process  and  finished  goods 
may  all  require  adjustment  at  closing  time.  The  remarks  appli- 
cable to  investments  will  apply  equally  well  to  materials  and 
supplies.  No  one  can  object  to  their  being  carried  at  cost,  because 
of  the  fact  that  it  is  intended  that  they  shall  be  used  in  the  product 
and  not  sold.  Hence  the  market  value  can  have  little  effect  upon 
them.  There  would  be  no  more  excuse  for  writing  down  materials 
and  supplies  than  for  writing  them  up.  They  are  written  down 
in  accordance  with  the  theory  that  the  market  has  fallen  and 

237 


Principles  of  Accounting 

they  could  be  produced  now  at  a  lower  figure  than  formerly.  It 
would  seem  to  make  little  difference  whether  the  excess  of  cost 
over  market  were  written  down  to  profit  and  loss  or  whether  it 
were  charged  into  the  product  at  cost.  On  the  other  hand,  it 
would  seem  absurd  to  take  a  fictitious  profit  on  them  and  charge 
them  into  the  cost  at  a  higher  rate  if  the  market  had  risen.  The 
point  at  issue  seems  to  be  entirely  one  of  whether  they  are  to  be 
valued  at  what  they  would  bring  in  the  market  or  at  what  they 
are  worth  for  manufacturing  purposes.  Ultra-conservatism  re- 
quires that  they  shall  be  carried  at  cost  when  cost  is  below  the 
market,  but  carried  at  the  market  when  the  market  is  below  cost. 
It  would  seem  that  if  it  is  desirable  to  take  cognizance  of  the 
relation  of  cost  to  the  market  price  that  this  might  be  accomplished 
through  the  medium  of  reserves  for  balance  sheet  purpose,  rather 
than  upsetting  the  costs  at  which  the  materials  and  supplies  are 
to  be  charged  into  the  product. 

Goods  in  process  may  have  included  in  them  in  certain  in- 
stances manufacturing  and  general  overhead.  Here  again  it  may 
be  necessary  to  resort  to  reserves  for  the  purpose  of  proper  valu- 
ation in  the  balance  sheet,  without  disturbing  the  function  of 
control  which  is  the  essential  of  these  accounts.  Stationery,  print- 
ing and  postage  will  likely  require  adjustment  in  closing,  unless 
arrangement  has  been  made  to  carry  both  asset  and  expense 
accounts  for  these  various  items.  Even  so,  it  will  frequently  be 
the  custom  to  defer  the  charge  of  these  items  to  expense  accounts 
until  just  before  closing  the  books. 

The  accounts  representing  the  current  assets  will  very  gen- 
erally call  for  adjustment  before  closing.  Cash  is  the  usual  ex- 
ception to  this  rule,  but  even  it  may  require  adjustment  on  account 
of  interest  on  bank  balances  and  similar  items.  Accounts  receiv- 
able will  need  to  be  scrutinized  so  as  to  determine  whether  or  not 
there  are  among  them  any  accounts  which  are  bad  or  doubtful. 
These  should  be  provided  for  through  the  medium  of  reserves 
rather  than  written  off.  Some  accounts  may  carry  interest,  which 
should  be  accrued  before  closing.  Notes  receivable  are  of  the 
same  character  and  must  receive  attention  with  regard  to  the 
interest  which  has  accrued  on  them. 

Special  and  miscellaneous  assets,  like  sinking  funds,  etc.,  may 
require  adjustment,  and  accounts  like  good-will,  insurance  and 
advertising  paid  in  advance  may  need  to  be  written  off  or  pro- 

238 


Accruals  and  Closing  Entries 

vided  for.  Consignments  may  also  have  to  be  taken  care  of  if 
consignments  have  not  been  carried  on  the  general  books.  Ac- 
counts sales  should  be  made  up  and  the  proper  entries  made  on 
the  books,  usually  charging  the  cost  of  sales  and  crediting  ac- 
counts payable  in  favor  of  consignors. 

With  regard  to  the  accounts  for  liabilities,  the  interest  on  any 
bonds  outstanding  should  be  accrued,  as  should  also  taxes,  wages 
and  the  interest  on  accounts  and  notes  payable.  If  there  are  any 
deferred  credits  to  income  they  should  be  examined  in  order  to 
determine  if  any  proportion  may  appropriately  be  taken  into  the 
earnings  of  the  period. 

In  a  similar  manner  the  nominal  accounts  should  be  gone 
through,  giving  attention  to  any  sales  made  in  the  period  not  yet 
booked;  also  any  returns  or  sales  allowances  pending  settlement. 
Attention  should  likewise  be  given  to  purchases  and  purchase  re- 
turns and  allowance.  Inventories  should  be  applied  and  the  proper 
cost  of  purchases  applicable  to  manufacturing  or  sales  should  be 
determined ;  salaries  of  superintendent,  office  salaries  and  expenses 
of  the  factory  accrued,  in  the  case  of  a  manufacturing  concern, 
and  the  true  cost  of  goods  sold  ascertained  by  means  of  the  in- 
ventories, unless  the  direct  method  of  ascertaining  the  cost  is  in 
vogue.  The  accounts  for  salaries  of  salesmen,  traveling  expenses 
of  salesmen,  commissions  and  advertising  should  be  carefully  gone 
into  for  accruals  and  adjustments  affecting  the  expenses.  Salaries 
and  expenses  of  the  general  office  should  likewise  be  treated. 

After  the  proper  entries  have  been  made  in  the  accounts  the 
nominal  accounts  may  be  closed  direct  to  profit  and  loss,  or  they 
may  first  be  closed  into  the  respective  group  accounts,  which  in 
turn  will  be  closed  into  profit  and  loss.  This  is  what  is  meant  in 
reality  by  closing  the  books.  Although  the  making  of  the  accruals 
and  the  preparation  of  the  balance  sheet  and  statement  of  income 
and  profit  and  loss  from  the  trial  balance  before  closing  has  come 
to  be  referred  to  technically  by  the  same  expression,  it  makes 
little  difference  practically  in  the  preparation  of  the  statement  of 
income  whether  or  not  the  nominal  accounts  have  actually  been 
closed.  If  they  have  been,  it  will  be  necessary  to  analyze  the 
profit  and  loss  account,  or,  in  other  words,  pick  the  items  out  of 
said  account.  Whereas,  if  the  nominal  accounts  have  not  actually 
been  closed  out,  the  statement  may  be  prepared  from  the  trial 
balance  or  direct  from  the  accounts.    It  is  usually  easier  to  pre- 

239 


Principles  of  Accounting 

pare  the  statement  if  the  nominal  accounts  have  not  been  closed 
out.  Where  the  accounts  have  been  scientifically  arranged  the 
preparation  of  the  statements  is  greatly  facilitated,  since  the  items 
will  appear  in  the  statements  in  practically  the  same  order  that 
the  accounts  appear  in  the  books. 


240 


CHAPTER   XXXVII 

THE  PREPARATION  OF  FINANCIAL  STATEMENTS 

Financial  statements  may  be  generally  classified  as  follows : 

Balance  sheets ; 

Statements  of  income  and  profit  and  loss; 

Statements  of  affairs ; 

Deficiency  accounts; 

Statements  of  realization  and  liquidation ; 

Statements  of  receipts  and  disbursements. 

It  is  not  improbable  that  various  kinds  of  statistical  statements 
may  be  included  in  this  classification.  It  is  thought,  however,  to 
be  more  consistent  to  confine  the  classification  to  the  above  and 
consider  statistical  tables,  which  are  invaluable  for  administrative 
purposes,  as  schedules  supporting  the  above  statements. 

There  has  been  much  discussion  concerning  the  various  names 
of  the  above-mentioned  financial  statements.  Concerning  balance 
sheets  it  would  seem  that  there  need  be  little  or  no  discussion. 
The  balance  sheet  may  be  general  or  detailed  in  the  manner  in 
which  the  information  is  presented.  It  may  be  condensed  or  con- 
solidated. Irrespective  of  these  matters  it  still  remains  a  balance 
sheet.  The  question  is  sometimes  raised  as  to  whether  it  is  more 
appropriate  to  present  it  in  account  form  or  report  form.  There 
would  seem  to  be  but  one  answer  to  this  question,  and  that  is: 
whichever  suits  the  fancy  of  the  person  who  is  preparing  the  bal- 
ance sheet.  The  information  is  there,  whether  assets  and  liabilities 
are  presented  side  by  side  or  one  group  above  the  other. 

With  regard  to  the  statement  of  income  and  profit  and  loss 
there  is  perhaps  room  for  more  discussion.  One  author  has  tabu- 
lated the  different  names  by  which  this  statement  is  known  and 
presents  some  fifteen  of  such.  It  has  been  variously  referred  to 
as  the  profit  and  loss  account,  the  income  and  profit  and  loss 
account,  the  trading  and  profit  and  loss  account,  the  manufactur- 
ing, trading  and  profit  and  loss  account,  etc.,  etc.  The  informa- 
tion contained  should  be  the  same,  no  matter  by  which  name  the 

241 


Principles  of  Accounting 

statement  is  known.  It  will  he  observed  that  the  difference  seems 
to  occur  in  that  some  are  known  as  statements  and  some  as  ac- 
counts. The  difference  is  usually  technically  referred  to  as  that 
which  exists  between  the  account  form  and  the  report  form.  The 
account  form,  as  its  name  implies,  contemplates  the  presentation 
of  the  information  classified  and  arranged  with  regard  to  debit 
and  credit.  The  report  form  undertakes  to  present  the  informa- 
tion more  or  less  in  narrative  or  running  form,  deducting  debits 
from  credits  and  vice  versa.  The  especial  advantage  of  the  report 
form  is  that  it  is  adapted  to  comparison. 

The  balance  sheet  is  a  financial  statement  which  shows  the 
financial  condition  of  an  organization  at  a  given  moment  of  time. 

The  statement  of  income  and  profit  and  loss  is  a  financial  state- 
ment which  sets  forth  the  financial  operations  of  an  organization 
comprehensively  grouped  about  the  divisions  of  organization  and 
connecting  the  financial  condition  of  the  organization  at  two 
different  dates. 

A  statement  of  affairs  is  a  financial  statement  setting  forth  as 
an  estimate  the  deficit  and  the  amount  which  unsecured  creditors 
would  receive  through  enforced  realization  and  liquidation  and 
the  relative  positions  of  preferred  and  secured  creditors. 

A  deficiency  account  is  a  financial  statement  which  serves  to 
explain  the  manner  in  which  a  deficit  has  occurred  and  to  connect 
the  deficit  with  the  proprietorship  as  shown  on  the  balance  sheet. 

A  statement  of  realization  and  liquidation  is  a  financial  state- 
ment which  shows  through  the  realization  of  assets  and  the  liquid 
dation  of  the  liabilities  the  reduction  of  net  assets  to  cash. 

A  statement  of  cash  receipts  and  disbursements  is  a  financial 
statement  of  an  organization  which  shows  the  actual  cash  received 
and  the  actual  cash  paid  over  any  given  period  of  time,  together 
with  the  balances  at  the  beginning  and  at  the  end  of  the  period, 
respectively. 

Of  the  above  the  balance  sheet  and  income  statement  are  most 
prominent.  They  appear  in  connection  with  a  going  concern, 
whereas  a  statement  of  affairs  and  deficiency  account  arise  in 
connection  with  insolvency  as  a  rule,  while  the  statement  of  reali- 
zation and  liquidation  shows  the  subsequent  transactions  of  the 
receiver.  The  purpose  of  the  balance  sheet  is  to  set  forth  the 
financial  condition.  The  purpose  of  the  statement  of  income  is  to 
set  forth  the  storv  of  operations.      Each  must  be  complete  as  to 

242 


The  Preparation  of  Financial  Statements 

content  and  arranged  comprehensively  if  it  is  to  be  of  use.  In 
considering  this  point  it  may  be  well  first  to  look  for  a  moment  at 
the  parties  at  interest  in  an  organization.  These  are,  first,  those 
who  contribute  the  capital  or  finance  the  organization;  second, 
those  who  manage  the  organization ;  and,  third,  those  who  develop 
relations  with  the  organization  as  debtors  and  creditors.  The 
classification  of  parties  is  apparently  broad  enough  to  cover  any 
contingency,  since  the  respective  parties  are  connected  with  phases 
which  are  fundamental  to  organization.  Under  the  head  of  con- 
tributors of  capital  we  find  sole  proprietors,  copartners,  stock- 
holders, members,  and,  in  the  case  of  municipalities,  taxpayers. 
Each  of  these  is  interested  in  knowing  that  his  funds  have  been 
not  only  advantageously  employed,  but  that  they  are  secure. 
Financial  statements  offer  a  means  of  satisfying  the  desire  for 
such  information.  To  the  manager  they  offer  in  the  same  way 
a  means  of  satisfactorily  accounting  for  his  stewardship,  but  they 
also  furnish  him  with  excellent  facilities  for  getting  in  touch  arti- 
ficially with  the  divisions  of  his  organization .  which  size  or  other 
conditions  prevent  him  from  coming  into  personal  contact  with  and 
thus  transcending  the  limits  of  his  personal  observation.  Through 
his  financial  statenjents  he  is  offered  an  opportunity  of  extending 
his  administrative  functions  to  the  most  remote  and  insignificant 
portions  of  his  plant.  As  to  the  outsiders,  comparatively  little  can 
be  said  concerning  debtors.  The  creditors,  however,  play  an 
important  part.  Before  trade  creditors  or  banks  will  extend 
credit  or  make  loans  they  must  know  that  the  concern  is  in  good 
financial  condition  and  what  its  prospective  earning  power  is. 
Both  these  facts  may  be  disclosed  by  balance  sheets  and  statements 
of  income. 

In  short,  it  would  seem  that  financial  statements  which  would 
convey  the  proper  information  to  the  administrative  officers  would 
be  perfectly  satisfactory  to  any  one  of  the  other  parties  at  interest. 
There  has  been  omitted  from  this  classification  of  parties  the 
government,  and,  while  the  government  may  be  admitted  as  a 
party  at  interest,  for  some  reason  or  other  it  appears  that  state- 
ments that  are  perfectly  comprehensive  and  satisfactory  to  every 
one  else  are  not,  as  a  rule,  satisfactory  to  the  government.  It 
seems  to  be  customary  for  the  government  in  the  majority  of 
cases  to  insist  on  financial  statements  in  the  form  of  reports  which 
differ  entirely  from  the  usual  run  of  financial  statements  and  are 

243 


Principles  of  Accounting 

understood  with  difficulty  by  the  parties  who  are  required  to  pre- 
pare them.  In  many  cases  they  do  not  appear  to  follow  any 
known  rules  of  accounting  and  the  results  obtained  at  times  are 
little  short  of  ridiculous.  It  is  difficult  to  see  just  why  balance 
sheets  and  statements  of  /ncome  and  profit  and  loss  which  are 
ordinarily  accepted  as  being  clear  and  comprehensive  are  not 
received  and  used  by  the  government. 

A  classified  balance  sheet  would  appear  to  meet  the  require- 
ments of  all  interested  parties.  By  classified  balance  sheet  is 
meant  one  in  which  the  assets  and  liabilities  are  classified.  Assets 
are  of  several  kinds,  namely:  capital,  working  and  trading, 
current,  miscellaneous  and  deferred.  Liabilities  follow  very  much 
the  same  order,  namely:  capital,  current,  miscellaneous  and 
deferred.  Such  a  classification  would  give  to  any  one  interested 
information  concerning  the  assets  and  liabilities.  It  would  also 
enable  any  one  to  compare  any  group  of  liabilities  with  any  corres- 
ponding group  of  assets.  As  to  the  general  arrangement,  a  great 
deal  of  discussion  has  been  had.  There  are  those  who  contend 
that  the  current  assets  should  be  shown  first,  arranging  them  in 
the  order  in  which  they  will  be  realized ;  that  the  current  liabilities 
should  appear  at  the  head  of  the  statement  on  the  other  side, 
arranged  in  the  order  in  which  they  will  be  liquidated.  Others 
contend  that  capital  assets  and  liabilities  respectively  should  head 
the  statement.  Those  who  argue  for  preference  for  the  current 
assets  and  liabilities  seem  to  have  principally  in  mind  the  interest 
of  creditors,  and  they  also  seem  to  go  on  the  assumption  that  the 
business  is  to  be  liquidated.  Those  who  prefer  the  capital  assets 
and  liabilities  seem  to  look  at  the  situation  from  the  standpoint  of 
the  proprietor  or  stockholder.  With  a  little  care  in  the  arrange- 
ment it  would  seem  that  every  one  might  be  satisfied.  If  the 
capital  assets  and  capital  liabilities  are  placed  at  the  top  of  their 
respective  sides  of  the  balance  sheet  the  working  and  trading 
assets  follow  the  capital  assets,  and  these  in  turn  are  followed  by 
the  current  assets ;  whereas  the  capital  liabilities  are  followed  by 
the  current  liabilities,  then,  subject  to  consideration  of  miscel- 
laneous assets  and  liabilities  and  deferred  charges  to  expense  and 
credits  to  income,  there  may  be  seen  at  a  glance  not  only  how 
the  capital  has  been  invested  and  maintained  but  the  relation  of 
current  liabilities  to  current  assets.  It  is  an  easy  matter  to  show 
the  logical  order  of  assets  and  liabilities  with  regard  to  realization 

244 


The  Preparation  of  Financial  Statements 

and  liquidation  in  the  case  of  a  going  concern,  whereas  it  is  much 
more  difficult  to  attempt  to  state  the  order  of  realization  and 
liquidation  in  case  a  concern  is  to  be  wound  up.  The  following 
balance  sheet,  while  far  from  exhaustive,  will  serve  to  illustrate 
in  a  general  way  the  classification  and  arrangement  suggested : 

THE  HARFORD  COMPANY 

GENERAL   BALANCE   SHEET,    JULY    3I,    I912 


ASSETS 


LIABILITIES    AND    CAPITAL 


Plant     and     Property, 
schedule  No.  i 


Investments, 
No.  2 


schedule 


Treasury  stock. 


Patents,  trademark  and 
good-will,  schedule 
No.  3 


Inventories, 
No.  4...- 


schedule 


Current  assets: 

Cash  in  hand  and  on 
dep.,  sched.   No.  5^ 

Accounts  receivable.. 

Drafts  and  notes  re- 
ceived and  interest 

Due  from  subscribers 
to  capital  stock.. . 


$140,828.70 


71,228.89 


5,000.00 


34,15741 


35,436.35 


$42,757-84 
45,036.72 

9,34372 

197,280.00 


Total  cur.  assets..    $294,418.28 


Sinking  fund. 


400.00 


Deferred  charges  to  ex- 
pense, schedule  No.  6 


13,371.11 


Total  assets $594,840.74 


First  mortgage  bonds : 


Less  unissued 

40,000.00 

Issued  and  outstand'g 

$160,000.00 

Loans  payable,  and  int. 

58,011.59 

Current  liabilities : 

Taxes  accrued 

$73.15 

Salaries    and    wages 

accrued  

7,832.08 

Accounts  payable — 

8,264.40 

Notes  and  drafts  pay- 

able, and  interest. . 

16,307.17 

Expenses  accrued 

500.00 

Dividend  payable 

1,297.50 

Int.  ace.  on  ist  mtge. 

bonds  

800.00 

Total  current  liabil.. 

$35,074.30 

Reserves,  sched.  No.  7 

3,221.61 

Capital  stock— pref'd : 

Authorized 

$500,000.00 

Less  unissued 

413,500.00 

Issued  and  outstdg. 

$86,500.00 

Common : 

Authorized 

$500,000.00 

Less  unissued... 

475,000.00 

Issued  and  outstdg.  $25,000.00 

Total  cap'l  stock  is- 

sued &  outstand'g 

$111,500.00 

Capital  stock  subsc'd 

$219,200.00 

Profit  and  loss  surplus. 

2,833.24 

Cap'l  surp.,  donated  stk. 

5,000.00 

Total  liabil.  &cap'l.. 

$594,840.74 

Exhibit  **A* 


245 


Principles  of  Accounting 

SCHEDULES  SUPPORTING  GENERAL  BALANCE 
SHEET,  JULY  31,  1912 

Plant  and  property — schedule  No.  i : 

Land  and  buildings $107,500.00 

Additions  to  buildings 12,500.00 

Plant  equipment 13,200.00 

Horses,  wagons  and  motors 5,664.00 

Furniture  and  fixtures 1,964.70 

$140,828.70 


Investments — schedule  No.  2: 

Securities  owned $64,900.00 

J.  M.  Carlton,  receiver 3,764.00 

Retail  department 2,564.89 


$71,228.89 


Patents,  trademarks  and  good-will- 
No.  3: 

Patents  and  trademarks 

Good-will 


-schedule 


$9,916.67 
24,240.74 

$34,157.41 


Inventories — schedule  No.  4: 

Stores  department $3,618.39 

Manufacturing  department 12,272.15 

Finished  goods  manufacturing 12,986.91 

Finished  goods  trading 5,892.21 

Subdividing  department 527.84 

Shipping  department 56.40 

Boxmaking  department 20.00 

Coal-oil  and  waste , 38.95 

Stable  and  garage  supplies 8.50 

Postage 15.00 


^46 


$35436.35 


The  Preparation  of  Financial  Statements 

SCHEDULES  SUPPORTING  GENERAL  BALANCE 

SHEET,  JULY  31,  1912  {Continued) 

Cash  in  hand  and  on  dep. — schedule  No.  5 : 

Cash  in  bank $40,871.33 

Imprest  cash 100.00 

Expense  funds 525.00 

Freight  deposit 31.51 

Deutsche  Bank 1,230.00 


$42,757.84 


Deferred  charges  to  expense — sched.  No.  6 : 

Discount  on  bonds $9,958.34 

Legal  expense  deferred 1,250.00 

Organization  expense 995-03 

Insurance 926.00 

Rent  paid  in  advance 5.81 

Advertising 208.00 

Freight  on  consigned  goods 27.93 


$i3»37i.n 


Reserves — schedule  No.  7: 

For  depreciat'n,  buildings  and  equipment  $1,340.75 

For  doubtful  accounts 7^^-77 

For  containers 1,098.09 


$3,221.61 


There  are  a  number  of  controversial  points  which  arise  in 
connection  with  balance  sheets.  Prominent  among  these  is  the 
order   which  the  current  assets   shall   take.    These  should  be 

247 


Principles  of  Accounting 

arranged  in  the  order  in  which  they  will  ordinarily  be  realized, 
namely:  cash,  accounts  receivable,  notes  receivable.  In  the  case 
of  a  going  concern,  if  goods  are  not  sold  for  cash  they  are  sold 
on  account.  When  the  customer  finds  out  that  he  cannot  pay 
the  account  as  promptly  as  he  expected  to  he  asks  for  a  further 
extension  of  time  and  offers  his  note.  It  should  be  understood 
that  the  note  is  not  any  better  security  than  the  account. '  What 
the  note  does  is  to  effect  an  agreement  as  to  the  items  making  up 
the  account  and  thus  render  it  unnecessary  to  prove  the  items  in 
the  account  should  litigation  arise.  It  has  often  been  argued 
that  a  note  may  be  realized  upon  much  more  quickly  than  an 
account,  since  notes  are  frequently  discounted.  It  may  be 
remarked  with  equal  truth  and  facility  that  accounts  in  some 
parts  of  the  United  States  are  in  effect  discounted.  While  both 
of  these  statements  may  be  true,  they  are  the  exceptions  to  the 
rule  that  an  account  will  ordinarily  precede  a  note;  however,  it 
seems  only  logical  to  give  preference,  in  the  order  of  arrangement, 
to  the  accounts  as  representing  the  bulk  of  the  credit. 

Similar  discussion  may  also  be  had  with  regard  to  current 
liabilities.  As  to  the  items  of  taxes  and  wages,  there  need  be 
little  argument,  since  the  law  makes  both  preferred  claims,  taxes 
and  all  claims  to  the  government  taking  preference  over  wages. 
The  same  argument  which  was  used  in  the  case  of  accounts 
receivable  and  notes  receivable  may  be  used  in  the  case  of  accounts 
payable  and  notes  payable.  Notes  are  not  preferred  over 
accounts,  but  rate  with  them  in  liquidation.  They  have  no 
stronger  claim  on  the  business  than  have  the  accounts  and,  in 
view  of  the  fact  that  in  the  history  of  the  business  transactions 
the  accounts  usually  precede  the  notes,  it  is  thought  consistent  to 
follow  this  arrangement  in  the  balance  sheet. 

Good-will  frequently  comes  up  for  discussion  and  the  question 
which  presents  itself  is  whether  it  shall  be  included  among  the 
capital  assets  or  as  a  miscellaneous  asset.  Its  allocation  depends 
entirely  upon  the  circumstances  surrounding  its  creation.  If  it 
is  purchased  in  exchange  for  assets  of  the  concern,  it  should  be 
included  as  a  capital  asset.  If  it  is  raised  by  the  concern  without 
having  been  acquired  in  exchange  for  value  which  can  be 
measured,  it  should  be  shown  as  a  miscellaneous  asset. 

Another  point  worthy  of  discussion  is  the  treatment  of  re- 
serves.    Many  accountants  follow  the  practice  of  deducting  the 

248 


The  Preparation  of  Financial  Statements 

reserves  from  the  respective  assets,  while  others  show  them 
broad.  The  reason  for  deducting  them  is  that  it  is  argued  that 
reserves  are  merely  bookkeeping  expedients  for  reducing  the 
values  of  certain  assets;  that  what  an  observer  is  interested  in 
when  he  looks  at  the  balance  sheet  is  the  net  value  of  the  asset; 
that  it  is  a  waste  of  time  and  source  of  annoyance  for  him  to  be 
obliged  to  find  the  reserve  on  the  liabilities  side  and  make  the 
necessary  deduction  from  the  asset.  This  is,  of  course,  a  prac- 
tical reason  for  the  treatment  just  suggested.  The  adherents  of 
the  other  theory,  which  holds  that  the  reserve  should  be  set  up 
broad,  seem  to  have  more  or  less  philosophy  on  which  to  base  the 
practice.  Their  reasoning  is  as  follows:  Proprietorship  is  the 
excess  of  assets  over  liabilities.  It  is  an  equity  in  all  the 
assets  taken  collectively.  The  proprietor  shares  with  creditors 
the  ownership  of  the  assets.  It  would  not  be  correct  to  assign 
certain  of  the  assets  to  creditors  and  to  say  that  the  equity  of  the 
proprietor  was  vested  in  the  remainder.  A  reserve  is  a  portion 
of  proprietorship  set  aside  for  a  particular  purpose.  Proprietor- 
ship being  an  equity  and  reserves  being  a  part  of  proprietorship 
they  may  not  be  deducted  from  any  specific  assets  any  more  than 
proprietorship.  The  Interstate  Commerce  Commission  makes  a 
distinction  between  reserves  for  depreciation  and  reserves  for 
other  purposes,  deducting  the  depreciation  reserves  from  the  assets 
and  setting  the  others  up  broad.  This  would  appear  to  be  a  good 
distinction.  There  is  nothing  in  the  idea  that  to  deduct,  or  not 
to  deduct,  reserves  has  any  bearing  on  the  relations  of  the  organ- 
ization to  fire  insurance  companies  in  the  case  of  a  fire  loss. 

Another  interesting  point  presents  itself  in  connection  with 
sinking  funds.  As  is  well  known,  sinking  fund  cash  may  be  used 
for  the  purpose  of  buying  up  bonds  of  the  company  before  they 
mature,  usually  at  a  slight  increase  over  par.  The  treatment  of 
such  purchases  and  the  manner  in  which  they  are  shown  in  the 
balance  sheet  takes  one  of  two  forms.  One  way  is  to  show  them 
broad.  The  other  is  to  deduct  them  from  the  liability  in  a  manner 
similar  although  on  the  opposite  side  to  that  in  which  reserves 
are  deducted  from  assets.  If  such  bonds  when  purchased  are 
actually  canceled  then  there  would  seem  to  be  no  question  about, 
the  treatment  to  be'accorcfed  them:""  That  is,  they  should  be 
charged  agamst  th^  liabiTity  ?or  bonds  outs^tanding,  thereby^ 
reducing  it.     In  this  way"  the  reduced  liability  would  appear  in^ 

249  r  : 


Principles  of  Accounting 

the  balance  sheet  without  any  question  concerning  it.  If,  how- 
ever, the  bonds  were  not  actually  canceled,  as  sometimes  happens, 
they  may  either  be  carried  on  the  balance  sheet  on  the  asset  side 
as  an  investment,  whereas  the  liability  in  full  is  shown  on  the 
opposite  side;  or  they  may  be  deducted  from  the  liability  side 
and  the  net  account  extended.  The  latter  method  would  seem 
to  be  preferable,  since  the  bonds  at  time  of  purchase  are  in  the 
possession  of  the  company  or  its  agent  and  there  can  be  no 
further  liability  to  the  public. 

Whether  investments  or  securities  owned  shall  be  classed  as 
fixed  or  capital  assets  or  as  current  assets  is  also  a  debatable 
point  and  will  depend  upon  the  purpose  for  which  they  are  held. 
It  is  not  probable  that  any  one  would  think  of  considering  shares 
of  stock  of  a  subsidiary  concern  held  for  purposes  of  control,  or 
desirable  affiliation,  as  a  current  asset.  On  the  other  hand, 
scarcely  anything  is  more  marketable,  nor  can  anything  be  more 
readily  converted  into  cash  as  a  rule  than  securities.  Since  we 
look  upon  current  assets  as  those  which  may  be  realized  upon  for 
the  purpose  of  liquidating  current  liabilities  it  would  not  seem 
amiss  to  class  securities  as  current  assets.  If  the  stocks  were 
pledged  as  security  for  some  capital  liability  it  would  seem  further 
to  complicate  the  situation.  We  might  sum  the  matter  up  by 
concluding  that  when  securities  are  held  for  purpose  of  control, 
affiliation,  permanent  investments  of  excess  capital,  or  when 
pledged  for  capital  liabilities,  they  are  to  be  considered  as  fixed 
or  capital  assets,  but  when  held  as  temporary  investments  of  excess 
capital,  until  the  time  when  the  usual  current  assets  will  not  be 
realized  upon  fast  enough,  or  when  pledged  as  security  for  current 
liabilities,  they  should  be  considered  as  current  assets.  As  to  ad- 
vances to  subsidiaries,  if  they  are  to  be  repaid  in  cash  they  are 
usually  considered  as  current,  whereas  if  they  are  to  be  repaid  in 
securities  they  are  considered  as  investments  under  fixed  or  capital 
assets,  since  the  securities  when  received  will  constitute  control  or 
affiliation. 

There  very  often  arises  in  connection  with  the  preparation  of 
balance  sheets  the  question  as  to  whether  or  not  consignments 
received  and  shipped  shall  be  shown  on  the  balance  sheet  and  if 
so  how.  The  best  practice  probably  dictates  the  use  of  a  memor- 
andum or  foot-note  showing  to  what  extent  consigned  goods  are 
on  hand.     If  consignments  received  are  to  be  carried  on  the 

250 


The  Preparation  of  Financial  Statements 

balance  sheet  at  all  they  should,  it  seems,  be  shown  on  the  asset 
side  as  the  very  last  item,  whereas  the  corresponding  account- 
ability should  appear  in  the  same  relative  position  on  the  liabilities 
side.  It  is  not  desirable  that  consignments  should  be  shown  as 
a  part  of  the  working  and  trading  assets  of  the  concern  in  order 
that  the  accounts  payable  on  the  other  side  include  as  a  liability 
the  corresponding  amount.  With  regard  to  consignments  shipped 
many  accountants  favor  ignoring  any  reference  to  them  in  the 
balance  sheet.  It  would  seem  that  they  might  with  propriety  be 
shown  therein  as  deferred  credits  to  income,  provided,  however, 
that  the  corresponding  amount  which  has  been  charged  to  ac- 
counts receivable  is  set  forth  separately  so  that  there  can  be  no 
question  as  to  the  value  of  the  accounts  receivable  in  so  far  as 
the  consignments  are  concerned. 

Notes  receivable  discounted  are  frequently  the  subject  of 
heated  discussion.  One  person  may  prefer  to  show  them  merely 
as  a  foot-note  with  the  statement  that  a  contingent  liability  exists 
in  connection  therewith  in  whatever  the  amount  may  be.  Another 
practice  consists  in  placing  the  contingent  liability  among  the 
current  liabilities  on  the  theory  that  the  notes  are  included  in  the 
current  assets.  Still  another  practice  excludes  the  notes  from  the 
current  assets  and  places  them  below  among  the  miscellaneous 
assets,  while  the  contingent  liability  offsetting  them  is  shown 
among  the  miscellaneous  liabilities.  It  is  important  that  this 
matter  should  not  be  overlooked,  since  notes  receivable  discounted 
play  an  important  part  many  times  in  the  financial  condition  of  a 
concern.  It  is  probable,  however,  that  the  preferable  practice  is 
to  make  mention  of  them  through  the  medium  of  a  foot-note  on 
the  balance  sheet. 

Where  the  details  of  certain  items  appearing  on  the  balance 
sheet  are  numerous  and  the  detailed  information  is  necessary  to  a 
comprehensive  statement,  it  is  customary  to  supply  them  in  the 
form  of  supporting  schedules.  Such  schedules  appear  most 
frequently  as  those  which  show  the  details  of  plant  and  equip- 
ment, securities  owned,  accounts  receivable,  notes  receivable, 
capital  stock  outstanding,  accounts  payable,  notes  payable,  etc. 
Schedules  are  also  used  in  the  case  of  co-partnership  to  show  the 
adjustment  of  proprietorship  as  affected  by  additions  and  with- 
drawals of  capital,  interest,  salary  and  division  of  profits,  etc. 
The  following  illustration  of  this  use  may  be  of  interest : 

2il 


Principles  of  Accounting 
HEMMINGWAY  &  BLAUVELT 

SCHEDULE       SHOWING       ADJUSTMENT       OF       PROPRIETORSHIP 
AFFECTED  BY  ENTRIES  DURING  THE   SIX    MONTHS   ENDED 
DECEMBER   3I,    I9II 


AS 


Total 
Proprietorship — ^July  i,  1911..  $53,900.00 


M.  Hem- 
mingway 
$26,950.00 


Add: 

Interest  on  capital $1,617.00 

Salary  of  manager 2,500.00 

Total $4,117.00 

Total $58,017.00 

Deduct — drawings 16,000.00 

Proprietorship,  as  adjusted....  $42,017.00 
Add  profits — six  months  ended 

Dec.  31,  1911 26,280.00 


$808.50 
2,500.00 


$3,308.50 


$30,258.50 
6,000.00 


$24,258.50 


17,520.00 


M.  Blau- 

v,elt 
$26,950.00 


$808.50 


$808.50 


$27,758.50 
10,000.00 


$17,758.50 
8,760.00 


Proprietorship — Dec.  31,  1911.  $68,297.00  $41,778.50  $26,518.50 

Consolidated  balance  sheets  and  income  statements  are  used 
to  show  the  combined  financial  condition  and  results  of  operations 
of  two  or  more  controlled  or  affiliated  companies.  They  are 
usually  prepared  in  cases  of  holding  companies  where  it  is  desir- 
able to  consolidate  the  showing  of  the  subsidiaries  with  those  of 
the  parent  company,  or  when  it  is  desired  to  know  the  combined 
financial  condition  and  operations  of  a  group  of  companies  about 
to  be  consolidated. 

The  holding  company  maintains  its  control  over  subsidiaries 
through  stock-ownership.  The  profits  from  the  subsidiaries  are 
taken  up  by  the  holding  company  through  dividends  on  the  capital 
stock.  The  stock  is  supplemented  at  times  by  bonds  so  that  in 
such  cases  the  income  of  the  holding  company  is  made  up  of 
both  dividends  on  stocks  owned  and  interest  on  bonds  owned.  As 
a  rule  the  holding  company  has  little  other  income. 


252 


The  Preparation  of  Financial  Statements 

There  may  be  financial  transactions  between  the  holding  com- 
pany and  its  subsidiaries,  such  as  advances  and  loans.  The  same 
transactions  may  also  take  place  among  subsidiaries  as  well  as 
inter-company  sales  of  materials  and  supplies,  parts  to  complete 
and  finished  goods.  The  mere  fact  of  the  existence  of  sucti 
transactions  is  sufficient  in  itself  to  raise  a  considerable  problem 
in  preparing  consolidated  statements,  but  the  problem  is  usually 
complicated  by  the  further  fact  that  such  inter-company  sales 
have  been  booked  as  sales  so  as  to  show  a  profit  instead  of  being 
mere  transfers  at  cost.  It  is  much  the  same  practice  as  that 
wherein  one  department  of  an  organization  turns  over  partly 
finished  product  to  that  which  performs  the  next  operation  at  the 
market  price,  allowing  departments  to  show  profits. 

From  the  above  it  will  be  seen  that  before  consolidated  state- 
ments may  be  prepared  considerable  work  must  be  done  in  recon- 
ciling the  various  accounts  pro  and  con  to  the  end  that  they  will 
agree  and  offset  one  another  when  they  are  put  together  for 
elimination.  The  most  common  accounts  which  require  such 
treatment  are  capital  stock,  bonds,  advances,  accounts,  notes,  in- 
terest, sales  and  consignments. 

Let  it  be  assumed  that  the  New  York  Mfg.  Company  is  a 
holding  company  owning  the  capital  stock  of  the  Bronx  Mfg. 
Company  in  the  amount  of  $100,000  and  the  capital  stock  of  the 
Manhattan  Mfg.  Company  in  the  amount  of  $500,000.  The  two 
latter  companies  as  subsidiaries  own  and  operate  plants  in  the 
respective  boroughs.  Let  it  be  further  assumed  that  the  cost  to 
the  holding  company  of  the  Bronx  Mfg.  Company  stock  was 
$95,000,  and  if  the  cost  of  the  Manhattan  Mfg.  Company  stock 
was  $525,000,  the  stocks  of  the  respective  operating  or  subsidiary 
companies  will  be  carried  on  the  books  of  the  holding  company 
at  $95,000  and  $525,000,  respectively.  The  earnings  of  the  hold- 
ing company  will  with  respect  to  these  investments  appear  in  the 
form  of  dividends  on  the  stocks.  If  the  Bronx  Mfg.  Company 
pays  an  annual  dividend  of  10  per  cent,  and  the  Manhattan  Mfg. 
Company  an  annual  dividend  of  12  per  cent.,  the  earnings  will 
appear  as  dividends  in  the  amounts  of  $10,000  and  $60,000, 
respectively,  except  in  the  case  of  a  consolidated  balance  sheet 
or  consolidated  statement  of  income  and  profit  and  loss.  These 
will  be  the  only  transactions  and  entries  appearing  on  the  books 
of  the  holding  company.     If,  however,  the  holding  company  has 

253 


Principles  of  Accounting 

other  assets  and  liabilities  and  other  income  and  expense,  and  it  is 
desired  to  show  the  combined  financial  condition  of  the  holding 
company  as  well  as  the  subsidiaries  and  corresponding  statements 
of  income  and  profit  and  loss,  then  it  will  be  necessary  in  prepar- 
ing the  statements  to  resort  to  certain  eliminations.  It  will  be  a 
matter  of  combining  the  assets,  liabilities,  income  and  expense  of 
all  the  companies.  Since  the  investments  in  the  subsidiary  com- 
panies have  been  shown  as  capital  stock  and  the  specific  assets  and 
liabilities  of  the  subsidiary  companies  are  to  be  brought  into  play 
so  as  to  show  their  true  financial  condition  in  place  of  the  invest- 
ments, it  will  be  necessary  to  offset  the  capital  stock  shown  as  the 
asset  on  the  books  of  the  holding  company  against  the  account- 
ability for  said  capital  stock  shown  on  the  books  of  the  subsidiary 
companies,  and  if  perchance,  as  is  the  case  here,  the  stocks  have 
not  been  carried  by  the  holding  company  at  par,  an  adjustment  of 
the  combined  surplus  of  the  three  companies  will  be  necessary.  In 
the  case  of  the  Bronx  Mfg.  Company,  from  the  point  of  view  of 
the  consolidated  balance  sheet,  the  capital  stock  carried  at  $95,000 
will  have  to  be  brought  up  to  par  and  the  consolidated  surplus 
correspondingly  increased  in  the  amount  of  $5,000.  The  stock 
of  the  Bronx  Mfg.  Company  carried  as  an  asset  by  the  New  York 
Mfg.  Company  may  then  be  offset  against  the  accountability  for 
capital  stock  outstanding  shown  by  the  Bronx  Mfg.  Company  in 
the  amount  of  $100,000.  In  a  similar  manner  in  preparing  the 
consolidated  balance  sheet  the  stock  of  the  Manhattan  Mfg. 
Company  carried  as  an  asset  by  the  New  York  Mfg.  Company  in 
the  amount  of  $525,000  will  have  to  be  adjusted  by  charging  the 
combined  surplus  with  $25,000,  so  that  the  capital  stock  as  an 
asset  may  be  offset  against  the  accountability  for  same  on  the 
books  of  the  Manhattan  Mfg.  Company.  The  dividends  shown 
as  earnings  by  the  holding  company  will  have  to  be  offset  against 
the  charges  for  dividends  on  the  part  of  the  subsidiary  companies. 
It  seems  scarcely  necessary  to  go  through  the  details  incident 
to  elimination  in  the  case  of  the  other  items  mentioned,  since  in 
each  case  the  procedure  consists  in  first  bringing  the  items  into 
agreement  with  respect  to  each  of  the  two  companies  involved 
and  then  offsetting  one  against  the  other.  It  should  be  noted,  of 
course,  that  eliminations  may  have  to  do  not  only  with  the  ac- 
counts between  one  subsidiary  and  the  holding  company  but  that 
similar  relations  may  exist  among  the  various  subsidiary  com- 

254 


The  Preparation  of  Financial  Statements 

panics.  Such  items  as  bonds  and  advances  will  usually  be  found 
in  cases  where  the  holding  company  is  involved  in  these  par- 
ticulars with  one  or  more  of  the  subsidiary  companies.  In  the 
cases  of  accounts,  notes,  interest,  sales  and  consignments,  the 
necessity  for  elimination  occurs  probably  with  greater  frequency. 
Inter-company  sales  where  same  have  been  recorded  at  the  prices 
at  which  goods  are  sold  to  outsiders  will  have  the  effect  not  only 
of  fictitiously  increasing  the  volume  of  sales,  but  in  cases  where 
certain  of  such  goods  remain  on  hand  at  the  time  of  taking  inven- 
tories such  goods  will,  unless  the  condition  is  corrected,  appear 
in  the  consolidated  balance  sheet  at  an  inflated  value.  It  is 
customary  to  correct  this  erroneous  statement  of  assets  by  making 
a  deduction  from  the  inventories.  In  cases  where  the  profits  are 
not  entirely  vested  in  the  inventories  the  correction  is  made 
through  the  medium  of  a  reserve.  There  is  presented  below  a 
specimen  consolidated  balance  sheet  and  a  statement  of  income 
and  profit  and  loss  accompanied  by  working  sheets  showing  the 
procedure  incident  to  their  preparation.  It  is  not  intended  to 
make  these  statements  exhaustive  or  even  complete  but  rather  to 
bring  out  the  principles  underlying  their  preparation : 


255 


Principles  of  Accounting 


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257 


Principles  of  Accounting 


NEW  YORK  MANUFACTURING  COMPANY 

CONSOLIDATED  BALANCE  SHEET — DECEMBER  3I,    igi2 

Liabilities  and  capital 


Assets 
Plant    and    equip- 
ment   

Securities  owned.. 

Inventories 


$545,000 
212,750 

134,000 


Current  assets : 

Cash $144,825 

Accounts  receiv- 
able    99,000 

Notes  receivable  33,75o 


Total    current 
assets  

Deferred     charges 
to  expense 


$277,575 


$11,075 


Capital  stock $500,000 

Bond    and    mort- 
gage payable. . .        $250,000 
Current  liabilities: 
Taxes  accrued..  $1,085 

Salaries  and 

wages  accrued  6,500 
Accounts      pay- 
able              51,575 

Notes  payable. .  265,000 

Total    current 

liabilities  . .        $324,160 
Reserve  for  inter- 
company profits.         $22,285 

Surplus $83,955 

Total  liabilities  and 

capital $1,180,400 


Total  assets . .     $1,180,400 
NEW  YORK  MANUFACTURING  COMPANY 

CONSOLIDATED    STATEMENT    OF     INCOME    AND     PROFIT    AND    LOSS 
FOR    THE    YEAR    ENDED    DECEMBER    3I,     I912 

Sales $485,875 

Cost  of  sales 185,000 

Gross  profit  on  sales $300,875 

Selling  and  administrative  expense 153,500 

Income  from  operations $147,375 

Other  income 23,940 

Total  income $171,315 

Deductions  from  income 1 5,075 

Net  income — profit  and  loss $156,240 

Dividends 30,000 

Profit  and  loss  surplus $126,240 

Provision  for  inter-company  profits  and  adjust- 
ments of  surplus 42,285 

Surplus — December  31,  1912 $83,955 


258 


y 


The  Preparation  of  Financial  Statements 


The  statement  of  income  and  profit  and  loss  appears  to  be  the 
work  of  evolution.  Statements  of  this  character  apparently  be- 
gan with  a  simple  profit  and  loss  statement  in  account  form  in 
which  the  nominal  accounts  were  classified  with  respect  to  debit 
and  credit.  This  statement  had  the  eflfect  of  connecting  the  bal- 
ance sheet  at  the  beginning  of  the  period  with  that  at  the  end, 
but  it  was  far  from  comprehensive.  It  showed  that  a  collection 
of  credit  items  exceeded  a  similar  collection  of  debit  items  and 
that  the  excess  of  credits  over  debits  was  equal  to  the  difference 
between  the  proprietorship  as  shown  by  the  first  balance  sheet  and 
that  of  the  second. 

A  demand  apparently  on  the  part  of  the  proprietor  for  infor- 
mation which  would  be  of  more  use  to  him  brought  out  the  trad- 
ing and  profit  and  loss  account.  This  was,  of  course,  used  only 
in  cases  of  concerns  engaged  in  trading.  For  manufacturing 
and  trading  concerns  there  was  a  similar  statement  which 
included  an  added  section  for  manufacturing  preceding  the  trad- 
ing section.  Doubtless  a  remark  to  the  effect  that  the  trading 
and  profit  and  loss  account  is  now  somewhat  passe  will  be  chal- 
lenged with  a  great  deal  of  vehemence.  There  are  many  who 
have  used  it  for  several  years  and  have  become  so  accustomed  to 
its  use  that  they  blindly  refuse  to  recognize  any  other  form  of 
statement.  An  unbiassed  investigation  of  the  relative  merits  of 
the  trading  and  profit  and  loss  account  and  the  statement  of  in- 
come and  profit  and  loss  must,  it  would  seem,  find  in  favor  of 
the  latter.  It  would  almost  appear  to  be  so  far  in  advance  of  the 
trading  and  profit  and  loss  account  as  not  to  permit  of  comparison. 

The  purpose  of  the  statement  of  income  and  profit  and  loss  is 
not  merely  to  connect  the  proprietorship  at  two  dates.  While 
this  is,  of  course,  essential,  its  prime  purpose  is  to  group  trans- 
actions of  the  period  around  the  three  main  functional  divisions 
of  organization,  so  that  such  information  will  be  of  administrative 
value.  It  also  aims  to  separate  from  the  above  mentioned  trans- 
actions those  incident  to  the  acquisition,  use  and  protection  of 
capital  and  to  classify  the  profit  resulting  not  only  with  regard  to 
its  origin,  but  to  show  the  income  from  operations  separate  and 
distinct  from  income  from  other  sources.  The  statement  takes 
the  report  form  rather  than  the  account  form.  It  is  thought  that 
this  makes  it  more  easily  understood  by  the  business  man,  who 
often  lacks  a  technical  knowledge  of  bookkeeping  and  accounting. 

259 


Principles  of  Accounting 

If  the  layman  were  attempting  to  ascertain  profits  he  would  set 
down  first,  probably,  his  sales.  From  these  he  would  deduct  the 
cost  of  his  sales.  With  just  this  same  thing  in  mind  the  statement 
under  consideration  is  begun  by  showing  the  gross  sales.  Real- 
izing that  returns  decrease  the  gross  sales  they  are,  therefore, 
deducted.  This  deduction  then  shows  the  net  sales.  Sales 
returns  are  quite  distinct  from  sales  allowances.  The  latter  may 
take  the  form  of  trade  discount,  rebates,  allowances  for  breakage, 
damage,  loss  in  transit,  etc.  These  allowances  may  be  supple- 
mented by  outward  freight  and  cartage  and  together  will  con- 
stitute the  deductions  from  sales,  so  designated  because  of  the  fact 
that  there  will  in  reality  be,  to  the  extent  of  the  deductions,  less 
income  produced  by  the  sales.  A  trading  concern  derives  its  in- 
come usually  from  two  sources.  The  principal  or  primary  source 
is  sales.  The  secondary  source  is  usually  interest  on  surplus 
capital.  It  is,  therefore,  thought  that  the  expression  income  from 
sales  may  be  appropriately  used  to  describe  that  earning  which 
results  after  deductions  from  the  net  sales  have  been  made.  The 
first  section  in  the  statement  may  be  said  to  constitute  the  sales. 
Following  this  there  comes  the  cost  of  the  goods  sold,  and  it 
should  be  borne  in  mind  that  the  construction  of  this  group  will 
depend  upon  whether  the  concern  is  engaged  solely  in  trading  or 
in  manufacturing  and  trading.  If  engaged  in  trading  solely,  the 
problem  is  a  very  simple  one  and  the  section  may  show  first  the 
inventory  at  the  beginning  of  the  period,  plus  the  purchases,  less 
the  inventory  at  the  end  of  the  period,  with  the  cost  of  goods 
sold  resulting;  or  it  may  show  simply  as  one  item  the  cost  of  tlie 
goods  sold  without  showing  how  the  amount  is  arrived  at.  If, 
however,  the  concern  is  engaged  in  manufacturing  its  own  goods 
the  situation  changes  considerably.  Here  it  may  be  necessary  to 
show  the  inventory  of  materials  and  supplies  at  the  beginning  of 
the  period,  the  purchases,  including  inward  freight,  inward  cartage 
and,  in  some  cases,  duty ;  the  returns  and  allowances  in  connection 
with  purchases,  the  inventory  of  materials  and  supplies  at  the  end 
of  the  period,  with  the  materials  and  supplies  applicable  to  cost 
resulting.  In  addition  to  this  there  will  be  the  manufacturing 
expenses,  such  as  superintendence,  heat,  light  and  power,  manu- 
facturing supplies,  factory  office  salaries  and  expenses,  repairs 
and  renewals,  depreciation  of  machinery  and  tools, "  etc.  The 
total  at  this  point  will  of  necessity  be  treated  with  the  differences 

260 


The  Preparation  of  Financial  Statements 

of  inventories  of  goods  in  process  and  finished  goods  respectively, 
in  order  to  arrive  at  the  cost  of  the  goods  sold.  The  total  cost  of 
sales  resulting  from  the  second  section  will  be  deducted  from  the 
income  from  sales,  as  shown  in  the  first  section,  and  the  gross 
profit  of  sales  resulting  will  be  brought  down.  From  this  figure 
will  be  deducted  that  resulting  from  the  third  section,  or  selling 
expense,  and  the  excess  brought  down  will  be  selling  profit. 
Selling  profit  is  a  somewhat  new  term  and  will  not  be  as  generally 
understood  as  gross  profit.  In  fact,  it  is  a  sub-division  of  gross 
profit  as  found  in  the  trading  and  profit  and  loss  account.  This 
latter  account  combined  the  selling  expenses  with  the  cost  of 
goods  sold  and  opposed  the  combined  result  against  sales,  showing 
the  balance  as  gross  profit  on  sales.  It  would  appear  that  this 
gross  profit  might,  with  consistency,  be  further  divided,  and  that, 
in  short,  is  what  has  been  attempted  in  the  statement  of  income 
and  profit  and  loss.  It  is  thought  that  this  further  classification  of 
profit  has  distinct  advantages  over  the  former  classification,  since 
it  may  be  very  important  to  know  to  what  extent  the  gross  profit 
on  sales  is  reduced  by  selling  expenses.  Administrative  expenses 
comprise  the  next  section  and  are  deducted  in  turn  from  the 
selling  profit  in  order  to  ascertain  the  net  profit  on  sales.  This 
profit  is,  in  fact,  the  income  from  operations,  or  the  primary  in- 
come, since  it  is  the  prime  object  of  the  concern  to  engage  in  the 
manufacture  and  sale  of  goods  for  the  purpose  of  profit.  With 
respect  to  the  various  classes  of  profit  above  described,  it  will  add 
to  the  value  of  the  statement  if  there  is  shown,  with  regard  to 
gross  profit,  selling  profit  and  net  profit  respectively,  the  percent- 
age of  cost. 

The  secondary  income  is  usually  added  to  the  income  from 
operations,  in  order  to  determine  the  gross  income.  From  this 
figure  there  is  then  deducted  the  items  which  offset  the  other  in- 
come and  which  are  commonly  known  as  deductions  from  income. 
The  figure  resulting  then  becomes  net  income,  or  profit  and  loss. 
With  regard  to  these  two  sections,  the  statement  will  vary  at 
times.  The  principal  variation  consists  in  combining  other  income 
and  deductions  from  income  into  one  section  and  either  adding 
or  deducting  the  net  figure,  as  the  case  may  be,  to  or  from  the 
income  from  operations.  The  result  produced  will,  however,  in 
each  case  be  the  same,  the  form  of  setting  up  the  information 
varying. 

261 


Principles  of  Accounting 

At  this  point  a  question  sometimes  arises  concerning  certain 
items  as  to  whether  they  shall  be  considered  as  income  or  de- 
ductions therefrom,  or  profit  and  loss  debits  and  credits  in  accord- 
ance with  their  character.  It  is  sometimes  fairly  difficult  to  decide 
whether  a  certain  item  is  a  profit  and  loss  charge  or  a  deduction 
from  income.  The  controlling  factor  in  deciding  this  point  is 
whether  or  not  the  charge  recurs  with  regularity  and  consistency 
and  is  connected  with  the  income.  It  will  usually  be  found  upon 
investigation  that  most  of  these  questionable  items  should  be 
included  as  profit  and  loss  charges  and  credits  rather  than  items 
of  income  or  deductions  therefrom.  To  the  "net  income — profit 
and  loss,"  there  should  be  added  any  profit  and  loss  credits  applic- 
able to  the  period.  From  the  total  of  these  there  should  then  be 
deducted  the  profit  and  loss  charges  for  the  period.  The  balance 
will  be  the  profit  and  loss  for  the  period.  It  may  be  found 
necessary  to  adjust  this  figure  on  account  of  debits  and  credits 
occurring  during  the  present  period  but  affecting  previous 
periods.  Such  adjustments  are  in  truth  adjustments  of  surplus, 
or  proprietorship  of  a  previous  period,  and  will  be  added  to  or 
deducted  from  the  profit  and  loss  for  the  period  after  it  has  been 
combined  with  the  previous  surplus  or  proprietorship.  The  final 
result  will  be  the  proprietorship  or  surplus  at  the  end  of  the  period 
and  should  agree  with  the  corresponding  items  on  the  balance 
sheet.  In  the  case  of  corporations  dividends  will  be  shown  in  the 
last  section  and  as  a  distribution  of  surplus. 

The  question  has  frequently  arisen  as  to  whether  the  profits 
for  the  period  should  be  connected  with  the  previous  proprietor- 
ship on  the  statement  of  income  or  on  the  balance  sheet.  The 
answer  to  this  is  that  it  is  very  largely  a  matter  of  personal  choice 
and  there  does  not  appear  to  be  very  much  reason  why  one  method 
is  not  as  good  as  another.  Tying  the  figures  up  on  the  balance 
sheet  reveals  the  profits  for  the  period  without  being  obliged  to 
refer  to  the  statement  of  income  in  case  one  does  not  care  to  see 
how  the  figures  are  arrived  at.  On  the  other  hand,  tying  them  up 
on  the  income  statement  relieves  the  balance  sheet  of  some  detailed 
information  which  sometimes  has  the  effect  of  making  it  appear 
complicated.  The  latter  method  is  preferred  by  the  writer,  for 
the  reason  that  it  permits  of  as  much  adjustment  as  is  desired 
without  detracting  at  all  from  the  appearance  of  the  balance  sheet. 
A  specimen  statement  of  income  and  profit  and  loss  follows : 

262 


The  Preparation  of  Financial  Statements 
THE  HARFORD  COMPANY 

STATEMENT   OF   INCOME   AND   PROFIT   AND   LOSS    FOR   THE    MONTH 
ENDED  JULY  3I,  I9I2 

Gross  sales $78,852.33 

Less — Returns   65.97 

Net  sales  $78,786.36 


Deductions  from  sales: 

Allowances $83.68 

Outward  freight  and  cartage 328.28 

Provision  for  reserve  for  containers 1,098.09 

Total  deductions  from  sales $1,510.05 

Income  from  sales $77,276.31 


Cost  of  goods  sold — (Factory  cost,  manufac- 
turing cost)  : 
Purchases — materials  less  transfers,  returns 

and  allowances  $28,686.39 

Purchases — containers 894.78 

Inward  freight  and  cartage 989.36 

Duty   1,882.34 

Proportion  stable  and  garage  expense 53-21 

Labor  expense  in  stores 122.65 

Total $32,628.73 

Deduct — Increase  in  inventory 1,743.00 

Purchases  applicable  to  cost $3o»885.73 

Direct  labor 20,650.07 

Superintendence  450.00 

Factory  office  salaries 400.48 

Heat,  light  and  power 320.69 

Factory  supplies  10.50 

263 


Principles  of  Accounting 

Factory  expense 1^-75 

Alterations,  repairs  and  renewals 22.75 

Provision  for  depreciation  of  buildings  and 

equipment   70-83 

Factory  office  expense 18.75 

Factory  operating  cost $52,842.55 

Add — Decrease    in    inventory — goods    in 

process  15,571.06 

Total  manufacturing  cost $68,413.61 

Subdividing   department    (expense) 6,703.64 

Box-making   department    (expense) 279.40 

Total  factory  cost $75>396.65 

Deduct  increase  in  finished  goods  inven- 
tory    8,407.37 

Total  cost  of  goods  sold $66,989.28 

Gross  profit  on  manufactured  goods  sold $10,287.03 

Gross  profit  on  trading  goods  sold 747-54 

Total  gross  profit  on  sales $11,034.57 

Selling  expyenses — Salaries : 

Sales  manager  and  clerks $484.00 

Salesmen 750.00 

Commission  897.23 

$2,131.23 

Traveling  expense 500.00 

Advertising 832.00 

Total  selling  expense $3,463.23 

Selling  profit $7»57i-34 

Administrative  expense : 

Salaries  of  officers $1,300.00 

Salaries  of  general  office  clerks 306.67 

264 


The  Preparation  of  Financial  Statements 

Stationery  and  printing  expense 8.50 

Postage  expense 16.38 

Telephone  and  telegraph 18.75 

General  office  expense 10.80 

Legal  expense 125.00 

General  expense 133-07 

Total  administrative  expense $1,919.17 

Net  profit  on  sales — income  from  operations..  $5,652.17 

Other  income : 

Income  from  retail  department $1,250.00 

Income  from  securities 515-75 

Commissions  earned 3.37 

Interest  on  bank  balances 135.62 

Interest  on  notes  receivable 13-69 

Cash  discount  on  purchases 2.33 

Total  other  income $1,920.76 

Total  income $7»572-93 

Deductions  from  income: 

Interest  on  first  mortgage  bonds  payable . .  $800.00 

Interest  on  bond  and  mortgage  payable. . .  156.16 

Interest  on  notes  payable 30.77 

Interest  on  loans  payable 633.09 

Cash  discount  on  sales 500.08 

Rent 40.00 

Insurance 9300 

Taxes 6.35 

Royalty  expense 76.30 

Total  deductions  from  income $2,335-75 

Net  income — profit  and  loss $5,237.18 

Profit  and  loss  credits: 

Profit  on  sale  of  Michigan  Central  bonds. .  $200.00 

Forfeited  subscription — L.  Wimbleton ....  250.00 

265 


Principles  of  Accounting 

Profit  on  exchange 41.34 

Profit  from  purchase  of  Minturn  Co.  stock.  764.00 

Total  profit  and  loss  credits $1,255.34 

Total $6,492.52 

Profit  and  loss  charges: 

Provision  for  depreciation — ^buildings  and 

equipment  $35^.33 

Provision  for  doubtful  accounts 775-34 

Provision  for  depreciation — furniture  and 

fixtures 6.24 

Good-will — ^written  off 1,010.03 

Organization  expense — ^written  off 16.91 

Discount  on  bonds — ^written  off 41.66 

Patents — written  ofif  83.33 

Expense — traveling  salesmen  —  underesti- 
mate by  Austin,  Bennett  &  Carlton 64.18 

Error — interest  on  J.  T.  Lawson's  note 5.76 

Total  profit  and  loss  charges $2,361.78 

Profi't  and  loss — surplus  for  the  period 4,130.74 

Dividend  declared $1,297.50 

Profit  and  loss  surplus — ^July  31,  1912 , . .       $2,833.24 

Exhibit  "B" 

The  statement  of  affairs  may  be  called  an  estimated  balance 
sheet,  and  it  should  be  noted  that  the  books  are  not  adjusted 
thereto.  Just  as  the  balance  sheet  in  the  condition  of  solvency 
shows  the  financial  condition,  so  the  statement  of  aflFairs  in  the 
case  of  insolvency  shows  the  estimated  financial  condition  based 
on  the  assumption  of  enforced  realization  and  liquidation.  As  the 
statement  of  income  and  profit  and  loss  shows,  in  the  case  of  sol- 
vency, how  the  profit  or  loss  occurred,  so  the  deficiency  account, 
in  the  case  of  insolvency,  explains  how  the  estimated  deficit  is 
arrived  at.  The  statement  of  affairs  may  be  said  to  parallel  the 
balance  sheet.  The  deficiency  account  may  be  said  to  parallel  the 
statement  of  income  and  profit  and  loss. 

266 


The  Preparation  of  Financial  Statement 

In  preparing  a  statement  of  affairs  it  should  be  borne  in 
mind  that  there  are  three  parties  interested  in  the  preparation  of 
the  statement:  first,  those  who  have  preferred  or  secured  claims; 
second,  those  creditors  who  are  unsecured;  and,  third,  the  pro- 
prietor. Preferred  and  secured  creditors  may  be  the  least  in- 
terested; the  unsecured  creditors  probably  the  most  interested. 
Another  important  matter  in  connection  with  the  preparation  of 
this  statement  is  the  point  of  view  to  be  maintained.  The  state- 
ment is  not  made  by  the  creditors,  or  from  the  point  of  view  of  the 
creditors,  but  by,  or  in  behalf  of,  the  proprietor,  in  order  to  show 
his  relation  to  the  creditors.  It  is,  therefore,  important  that  the 
point  of  view  should  be  precisely  the  same  as  that  which  is  taken 
in  the  preparation  of  the  balance  sheet.  No  authoritative  form  for 
this  statement  exists.  The  one  most  commonly  used  is  probably  the 
one  which  has  been  inherited  from  the  English  and  Scotch  ac- 
countants. This  form,  like  the  English  balance  sheet,  shows  the 
two  sides  in  the  transposed  order  from  that  used  by  Americans. 
It  has  been  suggested  that  the  reason  for  this  transposed  order  in 
the  case  of  the  statement  of  affairs  was  that  the  statement  repre- 
sented or  purported  to  show  the  relation  of  creditors  to  the  pro- 
prietor rather  than  the  opposite  of  this.  This  is  not  thought  to  be 
so,  and  the  reason  for  the  transposition  is  that  it  follows  the  Eng- 
lish form  of  balance  sheet.  Showing  it  thus  is  not  thought  by 
Americans  to  be  any  more  desirable  than  transposing  the  assets 
and  liabilities  on  the  balance  sheet,  and  to  do  so  only  results  in 
great  confusion  in  view  of  the  fact  that  there  are  numerous  con- 
tras  of  equities,  etc.,  to  be  deducted.  By  the  time  the  American 
student  has  transposed  the  two  sides  of  the  balance  sheet  and 
carried  equities  back  and  forth  once  or  twice  he  is  so  completely 
confused  that  it  becomes  almost  impossible  for  him  to  prepare  a 
correct  statement.  The  writer  favors  placing  the  assets  on  the 
left  and  the  liabilities  on  the  right,  arranging  them  respectively 
in  the  order  in  which  it  is  estimated  that  they  will  be  realized  and 
liquidated.  It  should  be  kept  in  mind  that  in  the  case  of  sole 
proprietors  and  co-partners  their  personal  estates  become  liable 
for  business  debts  and  such  assets  and  liabilities  should  therefore 
be  included  in  the  statement  of  affairs,  since  business  and  personal 
creditors  rate,  under  sole  proprietorship,  equally  in  the  distribution 
of  the  assets.  There  is  presented  below  a  statement  of  affairs 
and  a  deficiency  account : 

267 


Principles  of  Accounting 


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The  Preparation  of  Financial  Statements 
Deficiency  Account 


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ners' accounts 

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$50,000.00 
27,796.96 

$77796.96 

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Balance 

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tract   

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7,363.07 

$77,796.96 

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320.37 

3,160.73 

30,624.23 

$41,468.40 

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26,468.40 

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$41,468.40 

The  statement  of  realization  and  liquidation  purports  to  show 
the  reduction  of  the  assets  to  cash.  It  is  usually  the  statement 
which  is  made  up  to  show  the  accounting  of  the  receiver  or 
trustee.  Like  the  statement  of  affairs,  there  is  no  prescribed  form. 
There  has  been  in  use  for  some  time  a  realization  and  liquidation 
account,  for  which,  however,  it  is  difficult  to  find  any  authority. 
The  form  seems  to  have  been  the  creation  of  some  one  in  this 
country,  and  has  been  recognized  to  some  extent  by  the  various 
Boards  of  C.  P.  A.  Examiners.  It  is  not  practicable,  nor  is  it 
comprehensive.  It  seems  to  consist  in  making  a  number  of  debits 
and  credits  which  will  eventually  balance  one  another  and  it  does 
not  show  the  reduction  of  the  assets  to  cash  and  the  disposition  of 
such  cash.  A  practical  statement  of  realization  and  liquidation 
would  seem  to  begin  with  all  the  assets  and  liabilities  as  shown  by 
the  books.  A  columnar  arrangement,  with  the  assets  appearing 
above  the  liabilities,  would  seem  to  be  preferable.  In  the  next 
parallel  column  there  should  appear  any  new  assets  and  any  new 
liabilities  not  shown  on  the  books.  These,  added  to  those  shown 
by  the  books,  will  give  the  total  with  which  to  begin.  In  subse- 
quent parallel  columns  there  appear,  in  the  order  stated,  the  assets 
and  liabilities  not  realized  and  not  liquidated,  assets  and  liabilities 
to  be  accounted  for,  loss  and  gain  incident  to  realization  and  liqui- 
dation, and  last,  the  assets  and  liabilities  realized  and  liqui- 
dated. The  following  is  a  statement  of  realization  and  liquidation 
as  above  suggested : 

269 


Principles  of  Accounting 


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271 


Principles  of  Accounting 

The  statement  of  cash  receipts  and  disbursements  needs  little 
description  or  explanation.  It  should  preferably  be  in  report 
form,  in  order  to  facilitate  comparison.  It  should  begin  with  the 
balance  on  hand  at  the  beginning  of  the  period,  show  in  classified 
form  the  receipts,  the  total  accountability,  classified  disbursements 
and  balance  on  hand  at  the  end  of  the  period,  as  follows : 

THE  STANDARD  TRADING  COMPANY 

STATEMENT   OF   RECEIPTS   AND  DISBURSEMENTS   FOR   THE    MONTH 
ENDED  DECEMBER  3I,  I912 

Balance  November  30,  1912 $32,962.58 

Receipts  : 

Accounts  receivable $58,236.85 

Cash  sales 2,327.49 

Notes  receivable  and  interest 10,097.58 

Sale  of  land 5,350.00 

Rent  of  loft 250.00 

Sales  of  scrap 25.00 

Miscellaneous 12.37 

Total  receipts $76,299.29 

Total  accountability $109,261.87 

Disbursements : 

Accounts  payable $39,472.13 

Notes  payable  and  interest 25,536.25 

Rent 2,000.00 

Salaries 2,538.50 

Office  expenses 1,547.32 

Legal  expenses 500.00 

Miscellaneous  27.83 

Total  disbursements $71,622.03 

Balance — December  31,  1912 $37,639.84 

For  the  sake  of  completeness  a  realization  and  liquidation  ac- 
count is  presented  herewith : 

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«»FM1NCES  FO»  COLLATl»AL  IIAVIITG: 
AMOuntimc  Theory  »nA  Procedure.  Dickimson.  Chatter  VIIL 


CHAPTER  XXXVIII 

FINANCIAL  STATEMENTS  AS  AIDS  TO  ADMINISTRATION 

A  financial  statement  fails  miserably  in  its  object  unless  some- 
one examines  it  and  uses  it  as  the  basis  of  a  check-up.  Many 
a  wail  of  disappointment  has  been  heard  from  accountants  who 
have  prepared  statements  which,  in  addition  to  being  compre- 
hensive and  informative,  were  marvels  of  finish  and  beauty  from 
an  artistic  point  of  view,  because  the  recipient  of  the  statements, 
after  commenting  favorably  on  their  appearance,  put  them  care- 
fully away  in  his  safe,  never  to  remove  them  therefrom  until 
the  space  should  be  needed  for  their  successors. 

This  may  have  been  the  rule  in  the  past ;  but  if  so,  it  is  giving 
way  to  a  policy  on  the  part  of  business  men  which  prompts  them 
not  only  to  read  the  statements  with  care,  but  to  study  them,  to 
ask  questions  about  them,  and  to  act  on  the  information  elicited 
thereby. 

The  old  order  was  the  result  largely  of  ignorance  on  the  part 
of  the  business  man,  who  felt  secure  as  long  as  the  books  were 
in  balance ;  of  lack  of  vision  on  the  part  of  the  accountant,  who 
had  learned  to  prepare  financial  statements  after  more  or  less 
of  a  formula  without  giving  thought  as  to  the  significance  of 
the  statements,  and  whose  sense  of  duty  was  satisfied  with  their 
rendering. 

The  ideal  situation  is  that  wherein  the  business  man  and  the 
accountant  sit  down  together  and  discuss  the  conditions,  rela- 
tions, and  operations  which  the  statements  reflect.  One  of  the 
most  successful  business  men  of  the  present  time  not  only  does 
this,  but  refers  to  the  statements  daily  and  prepares  his  own  bal- 
ance sheet,  because  of  the  insight  into  the  affairs  of  his  business 
which  the  task  gives  him. 

Statements  to  be  effective  and  useful  must  be  rendered 
promptly.  Otherwise  the  status  from  which  conclusions  are 
drawn  may  have  changed  so  as  to  make  the  conclusions  worthless 
and  the  time  devoted  to  study  of  the  statements  of  little  use. 
There  are  instances  wherein  certain  circumstances  seem  to  inter- 
fere with  the  prompt  rendering  of  statements.  Observations 
extending  over  a  number  of  years  and  a  variety  of  cases  warrant 
the  statement  that  there  is  no  logical  excuse  for  tardiness  in  this 

274 


Financial  Statements  as  Aids  to  Administration 

respect.  Failure  may  be  traced  as  a  rule  to  lack  of  organization, 
inefficiency  in  management,  lack  of  ingenuity,  or  a  combination 
of  the  three.  It  is  absurd  to  hold  up  statements  which  are  nine- 
tenths  completed  because  the  one-tenth  part  of  the  information 
is  missing.  Estimates  based  on  experience  usually  suffice  in  cases 
of  this  kind.  Foreign  branches  and  affiliations  frequently  require 
such  treatment,  but  the  statements,  being  properly  qualified,  are 
read  with  such  reservations  in  mind. 

Statements  should  be  properly  tied  up;  meaning  that  where 
one  statement  relates  to  another  the  connection  should  be  shown. 
This  applies  particularly  to  balance  sheets  and  income  statements 
wherein  the  surplus  at  the  beginning  of  a  period  should  be  con- 
nected with  the  surplus  for  the  period,  and  the  total  surplus 
resulting  brought  into  agreement  with  respect  to  the  two  state- 
ments. Whether  this  reconciliation  of  surplus  should  appear  on 
the  balance  sheet  or  on  the  income  statement  is  the  subject  of 
some  difference  of  opinion,  and  is  treated  differently  by  different 
accountants.  It  seems  largely  a  matter  of  accounting  technique 
which  for  practical  purposes  should  doubtless  be  cast  aside. 
There  is  this  to  be  said,  however,  that  while  the  situation  may 
usually  be  brought  out  more  easily  on  the  income  statement,  there 
may  be  occasions  where  a  balance  sheet  will  be  exhibited  without 
the  income  statement.  In  this  event  there  is  but  one  avenue  open, 
namely,  to  show  the  tie-up  on  the  balance  sheet.  Instances  of 
this  kind  wherein  one  statement  is  used  without  the  other  are 
becoming  less  and  less  common.  A  former  idea  was  that  in  sub- 
mitting a  statement  for  credit  purposes  the  banker  would  be  sat- 
isfied with  a  condensed  balance  and  did  not  care  for  a  statement 
showing  the  operations.  It  was  considered  good  practice  to  give 
the  banker  as  little  information  as  possible.  The  modern  bank 
credit  man,  who  is  to  banking  what  the  mercantile  credit  man  is 
to  merchandising,  has  disabused  the  borrower's  mind  of  this  idea. 

The  statements  should  be  made  so  clear  that  anyone  with  a 
fair  amount  of  intelligence  may  understand  them.  The  clearer 
they  are  made  obviously  the  less  interpretation  is  needed.  Much 
progress  along  the  lines  of  clarity  has  been  made  by  the  introduc- 
tion into  the  statement  of  a  certain  amount  of  narrative.  Credit 
for  this  sort  of  thing  is  probably  due  either  the  Corn  Exchange 
Bank,  New  York,  or  the  Charity  Organization  Society,  New 
York.    Which  of  the  two  may  claim  priority  in  the  matter  is  not 

275 


Principles  of  Accounting 

known,  but  both  have  adopted  the  idea  of  explaining  their  state- 
ments in  such  a  way  that  they  may  be  understood  by  the  layman. 
The  bank  appeals  for  deposits ;  the  society,  for  funds  with  which 
to  carry  on  its  work. 

One  of  the  simplest  and  at  the  same  time  most  eflFective 
schemes  for  bringing  out  situations  is  comparison.  Probably 
no  one  expedient  may  be  found  which  will,  with  so  little  trouble, 
bring  out  so  much  information  as  the  comparison  of  items  on 
both  balance  sheet  and  income  statement  with  those  of  a  pre- 
ceding date  and  period.  A  balance  sheet  showing  figures  at  two 
dates  with  comparison,  will,  even  though  unaccompanied  by  an 
income  statement,  throw  a  considerable  amount  of  light  on  the 
employment  of  capital  or  the  financing  of  the  organization  dur- 
ing the  period  intervening  between  the  two  dates.  It  will  not, 
of  course,  show  the  details  of  operation  and  how  gain  or  loss  was 
occasioned,  but  it  is  surprising  how  much  information  may  be 
read  out  of  a  comparative  balance  sheet.  A  comparative  income 
statement  throws  light  on  the  operations  and  serves  more  as  an 
efficiency  index.  Much  value  is  derived  also  from  a  comparison 
of  monthly  income  and  expense  and  cumulative  figures  to  date 
with  the  corresponding  figures  of  a  budget.  There  is  a  decided 
tendency  to-day  in  the  direction  of  budgets.  The  federal  govern- 
ment is  perhaps  somewhat  responsible,  but  the  tendency  is  notice- 
able in  mercantile  and  industrial  organizations  as  well  as  those 
of  a  social,  civic,  or  philanthropic  character.  There  is  perhaps 
less  occasion  to  compare  current  with  previous  periods  where  there 
is  a  budget,  as  this  is  usually  compiled  largely  on  the  basis  of 
income  and  expense  for  the  preceding  period,  taking  into  con- 
sideration, however,  current  tendencies  and  probabilities. 

Financial  statements  should  be  studied  and  understood  by 
those  to  whom  they  are  rendered.  Directors,  for  example,  have 
a  duty  to  study  and  understand  them.  Where  the  directors  allow 
the  president  of  a  company  to  pile  up  an  indebtedness,  even 
though  he  has  rendered  statements  to  them  from  time  to  time, 
which  they  did  not  understand  or  question,  they  have  no  escape 
from  the  responsibility  which  attaches  to  their  position.  It 
behooves  directors,  officers,  or  anyone  charged  with  responsibility 
depending  on  financial  statements,  to  become  familiar  with  the 
conditions  represented  by  the  statements.  The  accountant  has 
a  duty  not  only  to  prepare  statements  which  are  correct  and 

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represent  facts,  but  to  explain  and  interpret  them  for  those 
whose  action  depends  upon  a  proper  understanding  of  the  facts. 
Accountants  have  been  particularly  deficient  in  this  phase  of  their 
work  in  the  past.  They  have  been  content  with  developing  a 
technique  which  often  has  been  of  no  interest  to  the  person  for 
whom  the  statements  were  prepared,  rather  than  interested  in 
placing  clear,  understandable  facts  before  such  person. 

The  accountant  is  powerless,  naturally,  to  force  the  responsible 
party  to  action  on  the  basis  of  facts  brought  out  by  his  state- 
ments. He  may,  however,  exert  a  powerful  influence  over  him 
directly  as  he  makes  matters  clear  for  him.  Many  business  fail- 
ures are  traceable  to  poor  management.  Back  of  poor  manage- 
ment is,  first,  lack  of  facts  from  which  to  administer ;  and  second, 
failure  to  act  on  information  available. 

Before  attempting  to  discuss  the  significance  of  points  pre- 
sented in  financial  statements,  it  may  be  of  help  to  consider 
briefly  the  parties  who  have  an  interest  in  such  statements. 

There  are,  first,  the  executives  who  are  officially  charged  with 
the  conduct  of  the  business  affairs  on  which  the  information  in 
the  statements  has  a  direct  bearing.  Then  follows  the  govern- 
ment, federal,  state,  county,  or  municipal,  any  claim  of  the  gov- 
ernment taking  precedence  over  all  other  indebtedness.  Thus  it  is 
of  utmost  importance  that  everything  should  be  clear  in  case 
government  agents  are  sent  to  investigate  in  connection  with  tax 
returns. 

Next  come  those  who  loan  capital  to  the  organization  on  long 
terms  and  who  are  usually  secured.  Their  inquiry  is  directed  at 
whether  or  not  interest  is  likely  to  be  earned  and  paid,  whether 
or  not  their  priority  rights  are  in  any  way  threatened  by  new 
capital  issues,  and  whether  or  not  compliance  is  being  had  with 
sinking  fund  provisions. 

Those  who  furnish  credit  for  short  periods  follow  in  order, 
and  to  them  the  question  of  interest  is,  primarily,  liquidity.  In 
other  words,  is  the  margin  of  profit  sufficiently  great,  the  volume 
of  business  sufficiently  large,  and  will  the  merchandise  be  con- 
verted into  cash  with  sufficient  rapidity  so  that  they  may  receive 
payment  for  goods,  services,  or  funds  furnished,  within  the  time 
specified  for  such  payment  when  the  credit  was  extended?  The 
interest  of  merchandise  creditors  should,  theoretically,  be  as 
keen  as  that  of  bankers  who  loan  money.    As  a  practical  matter 

277 


Principles  of  Accounting 

it  is  not,  because  they  do  not  have  the  same  faciHties  for  checking 
up  the  statements  as  have  the  bankers. 

Last  come  those  who  contribute  capital  to  the  enterprise.  They 
constitute  the  proprietary  group.  Whatever  is  left  after  others  are 
satisfied  belongs  to  them.  Their  interest  is  in  safety  of  principal 
and  reurn  on  investment. 

While  the  purpose  or  objective  of  business  enterprise  is  profit 
and,  as  a  corollary,  management  should  have  a  similar  purpose, 
it  must  be  said  that  one  of  the  prime  necessities  of  management 
is  to  maintain  satisfactory  relations  with  workers,  creditors,  gov- 
ernment, and  contributors  of  capital.  It  is  incumbent  upon  the 
management  to  see  that  workers  are  paid  promptly  as  well  as 
adequately;  that  risks  which  creditors  take  are  made  and  kept 
safe,  and  that  creditors  are  paid  in  accordance  with  the  terms 
under  which  the  credit  was  granted;  that  tax  reports  and  pay- 
ments are  made  to  the  government  at  proper  times ;  and  that  the 
return  to  those  who  comprise  the  proprietary  group  is  as  high 
as  possible  consistent  with  safety  of  principal  and  conservative 
financing. 

As  has  been  pointed  out,  difiFerent  phases  of  financial  condi- 
tions have  various  kinds  and  degrees  of  interest  for  different 
parties.  One  phase  which  is  of  general  interest  is  the  strength  of 
the  enterprise  as  denoted  by  the  excess  of  assets  over  liabilities. 
This,  ordinarily  designated  in  a  corporation  as  capital  and  surplus, 
has  recently,  on  account  of  suggestions  derived  presumably  from 
laws  providing  for  capital  stock  without  par  value,  been  set  up  as 
one  sum  and  without  distinction  being  made  between  capital  and 
surplus. 

The  admission  must  be  made  that  any  value  in  the  assets  In 
excess  of  the  liabilities  belongs  to  the  shareholders.  Once  pro- 
vision has  been  made  for  preferred  shareholders  out  of  such 
excess,  the  balance  belongs  to  the  common  shareholders.  Why 
then  is  it  necessary  to  show  such  excess  in  more  than  one  item? 
The  answer  is  best  found  in  the  suggestion  that  something  of 
historical  interest  and,  as  well,  an  idea  of  the  company's  operating 
strength,  are  lost  if  the  excess  is  shown  as  one  item. 

A  company  may  have  excess  assets  indicating  satisfactory 
financial  strength,  only  to  have  investigation  show  that  such 
excess  is  due  largely  to  a  revaluation  of  assets,  whereas  the  paid-in 
capital  has  been  impaired  by  operating  losses.    Granting  that  this 

278 


Financial  Statements  as  Aids  to  Administration 

condition  might  not  be  exposed  by  separating  the  surplus  from  the 
paid-in  capital,  insistence  on  the  latter  treatment  would  seem  to 
act  as  a  deterrent  to  those  who  favor  taking  up  increases  in  assets 
through  revaluations.  Conservatism  and  good  accounting  practice 
dictate  that  there  shall  be  shown  separately  (a)  capital  con- 
tributed, or  paid  in;  (b)  surplus  resulting  from  operations,  or 
earned  surplus;  and  (c)  surplus  resulting  from  revaluation  of 
assets,  or  capital  surplus. 

There  is  not  much  doubt  that  any  surplus  may  legally  be 
declared  away  as  dividends.  In  corporations  having  only  common 
capital  stock  without  par  value,  it  is  probable  that  any  excess  of 
assets  over  liabilities  may  in  most  states  be  so  declared  away,  as 
long  as  the  excess  is  not  decreased  below  the  amount  of  stated 
capital  required  by  the  charter  or  fixed  by  subsequent  action  of 
directors.  What  the  directors  may  do  legally  and  what  they  may 
do  as  a  matter  of  sound  business  policy,  are  two  different  things. 
While  they  may  be  within  their  legal  rights  in  insisting  that 
increases  representing  the  write-up  in  asset  values  shall  be  shown 
as  general  surplus,  thereby  giving  the  impression  that  such  surplus 
has  been  earned,  they  are,  from  an  accounting  point  of  view,  guilty 
of  making  a  misleading  statement.  Corporations  which  are  sound 
and  have  a  healthy,  earned  surplus  seldom  take  advantage  of  the 
legal  technicality;  which  permits  the  fiction  that  "surplus  is 
surplus."  It  is  usually  when  conditions  are  otherwise  unfavorable 
that  they  avail  themselves  of  the  legal  opportunity.  There  is 
nothing  gained  to  the  administration  in  a  statement  which  is 
misleading.  There  is  much  damage  which  may  result  from  the 
dissemination  of  information  which  is  misleading. 

Another  point  which  is,  or  should  be,  of  general  interest,  is  the 
relation  between  capital  which  has  been  received  as  a  contribution 
and  that  which  has  been  borrowed;  in  other  words,  owned  and 
borrowed  capital.  Stockholders  and  creditors  may  well  view  with 
alarm  an  increase  in  borrowed  capital  disproportionate  to  that  of 
the  owned  capital.  The  ideal  tendency  is  of  course  in  the  other 
direction.  This  aspiration,  while  worthy,  may  not  be  consistent 
with  an  ever-increasing  volume  of  business  which  demands  the 
reinvestment  of  a  large  portion  of  the  profits  in  order  to  keep  pace 
with  the  growth.  The  important  point  is  that  the  matter  should  be 
carefully  watched  and  proper  balance  maintained  between  the  two 
kinds  of  capital. 

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Principles  of  Accounting 

In  an  attempt  to  devise  a  ratio  which  will  bring  out  the  relation 
at  a  glance,  bank  credit  men  have  established  what  they  call  a 
"debt  to  net  worth"  ratio.  This  is  found  by  dividing  the  total 
debt  into  the  net  worth.  Such  a  ratio  may  show,  for  example,  that 
the  borrowed  capital  equals  25%  or  50%  of  the  owned  capital. 

The  basis  of  the  ratio  is  unsound,  since  the  true  relation  may 
only  be  brought  out  by  comparing  each  class  of  capital  with  the 
total  capital.  The  debt  to  net  worth  ratio  may  be  very  misleading 
under  certain  conditions,  but  it  has  been  quite  generally  accepted 
without  proper  investigation  or  consideration,  on  the  strength  of 
representations  made  in  all  sincerity  by  the  bank  men. 

By  way  of  illustration,  assume  that  in  a  given  enterprise  there 
is  a  total  capital  of  $500,000.  Of  this  $100,000  is  borrowed  and 
$400,000  is  owned.  The  borrowed  capital  is  equal  to  20%  of  the 
total  capital;  the  owned  capital,  80%.  If  sometime  in  the  future 
the  relations  should  change  so  that  of  the  total  capital,  $300,000 
would  be  borrowed,  and  $200,000  owned,  the  borrowed  capital 
would  then  constitute  60%  of  the  total,  and  the  owned  capital, 
40%. 

Using  the  "debt  to  net  worth"  method,  the  same  figures  will 
show  first,  that  the  borrowed  capital  is  25%  of  the  owned  capital, 
found  by  dividing  $400,000  into  $100,000.  It  will  show  under  the 
second  set  of  conditions  that  the  borrowed  capital  would  be  equal 
to  150%  of  the  owned  capital.  Comparing  the  two  percentages, 
the  span  shows  an  increase  from  25%  to  150%,  which  indicates 
that  the  borrowed  capital  has  increased  six  times.  This  sort  of 
showing  has  a  tendency  to  fill  the  hearts  of  the  proprietors  with 
fear,  and  perhaps  rightfully  so,  since  under  the  conditions  set 
forth  the  borrowed  capital  would  be  out  of  reasonable  relation  to 
the  owned  capital.  But  the  facts  are,  that  the  borrowed  capital 
has  only  increased  three  times,  or  from  $100,000  to  $300,000,  as 
would  be  shown  by  the  percentages  of  borrowed  capital  to  total 
capital,  namely  20%  and  60%. 

It  is  possible  that  the  bank  credit  men  may  have  had  some 
purpose  in  advocating  the  "debt  to  worth"  ratio,  since  it  makes 
the  worst  possible  showing,  by  magnifying  the  increase,  for  con- 
cerns which  are  working  on  too  much  borrowed  money.  The 
chances  are,  however,  that  it  is  simply  a  false  conclusion  drawn 
from  an  attempt  to  obtain  some  means  of  showing  quickly  the 
relation  of  the  two  capital  equities. 

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Financial  Statements  as  Aids  to  Administration 

The  current  or  liquid  aspect  of  financial  condition  is  concerned 
with  the  current  assets  and  current  liabilities.  This  aspect,  while 
of  vital  importance  to  those  who  supply  credit  for  short  periods, 
has  more  or  less  interest  for  all  parties  related  in  any  way  to  the 
organization,  except  debtors,  since  a  condition  wherein  a  concern 
is  unable  to  meet  current  obligations  may  bring  the  business  to  a 
sudden  halt  and  jeopardize  the  interest  of  everyone. 

Credit  men,  bank  and  mercantile,  have  established  the  two  to 
one  relation  between  the  current  assets  and  current  liabilities  as 
being  necessary  for  purposes  of  safety.  This  means  that  for 
every  dollar  of  liabilities  there  must  be  two  dollars  of  assets. 
They  admit  that  this  is  an  arbitrary  ratio  and  is  not  based  as  yet 
on  scientific  investigations  to  determine  Its  propriety.  But  like 
some  other  ratios,  it  has  been  accepted  because  it  has  been  adopted 
by  credit  men  and  imposed  as  a  requirement  upon  those  who  are 
obliged  to  seek  credit,  either  of  banks  or  mercantile  establishments. 
Bank  credit  men  have  already  seen  the  wisdom  of  giving  the 
matter  further  investigation  and  consideration.  They  have  already 
reached  the  conclusion  that  the  ratio  may  properly  vary  in  different 
lines  of  business  and  in  different  localities.  The  important  point 
is  that  a  safe  margin  shall  at  all  times  be  maintained  between 
current  or  liquid  assets  and  current  liabilities  so  that  the  liabilities 
as  they  fall  due  may  be  liquidated. 

There  is  something  to  be  said  about  the  items  which  should 
properly  be  Included  in  this  group  under  each  head.  No  one 
questions  such  items  as  cash,  accounts  receivable,  notes  receivable, 
raw  materials,  goods  In  process,  and  finished  goods.  The  bank 
credit  men  do  question  such  items  as  securities,  advances  to 
affiliated  companies,  accounts  or  notes  receivable  from  officers  or 
employes  of  the  company. 

The  last  two  may  generally  be  thrown  out  as  being  the  subject 
of  proper  objection,  although  there  are  cases  where  this  rule  has 
resulted  in  some  inconsistency.  Securities  are  somewhat  different. 
If  the  securities  represent  Investments  of  a  permanent  nature  they 
do  not  belong  In  current  assets.  When  they  represent  temporary 
investments,  or  funds  which  for  the  time  being  only  are  idle,  there 
is  no  reason  apparently  why  they  should  not  be  placed  in  the  group 
of  current  assets.  The  banker  takes  a  position  In  this  matter 
which,  although  somewhat  arbitrary  from  an  accounting  point  of 
view,  has  some  basis  of  logic  from  the  banker's  standpoint.    The 

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Principles  of  Accounting 

point  which  he  makes  is  that  if  the  prospective  borrower  has 
money  to  invest  in  securities  he  should  not  borrow  but  convert 
his  investments  into  current  funds.  Thus  if  funds  are  in  securities 
they  are  held  not  to  be  current  funds. 

Technically  it  appears  that  the  decision  should  be  based  on 
the  purpose  and  liquidity  of  the  investment.  If  the  investment 
is  for  ownership,  control,  or  advantage  through  affiliation,  for 
the  purpose  of  return  on  the  investment,  or  one  for  which  there  is 
little  or  no  market,  there  is  restriction  placed  on  its  conversion 
and  it  is  in  no  sense  current.  On  the  other  hand,  if  the  investment 
consists  of  readily  marketable  securities  which  may  be  converted 
as  quickly  as  need  be  for  the  purpose  of  obtaining  current  funds, 
there  is  no  doubt  about  its  inclusion  as  a  current  asset. 

The  banker  takes  a  similar  position  with  regard  to  advances. 
He  contends  that  his  function  is  to  supply  funds  for  temporary 
relief  or  assistance;  not  capital  financing.  Any  loans  on  the 
strength  of  advances  to  affi.liated  companies  make  the  banker  a 
party  to  the  financing  of  such  companies.  He  therefore  moves  to 
strike  out  advances  if  they  are  included  in  the  list  of  current 
assets. 

Again  the  procedure  is  based  on  an  arbitrary  position  taken 
by  the  banker  quite  properly  from  the  point  of  view  of  proper 
functioning  on  his  part.  But  from  an  accounting  point  of  view 
the  procedure  is  lacking  in  sound  basis.  Distinction  should  be 
made  between  advances  which  will  be  refunded  with  securities 
and  those  which  are  undergoing  current  realization.  Where 
current  funds  will  not  be  realized  from  advances  to  affiliated 
companies,  but,  instead,  realization  will  take  the  form  of  securities, 
there  is  no  justification  for  considering  the  asset  a  current  one. 
If,  however,  the  account  is  being  realized  currently,  there  appears 
to  be  no  reason  why,  for  current  ratio  purposes,  they  should  not 
be  treated  like  any  other  good  account  receivable. 

With  regard  to  current  liabilities  there  is  usually  very  little 
discussion,  except  where  they  are  involved  with  capital  liabilities 
which  become  payable  serially.  Following  a  more  or  less  arbitrary 
rule  for  which  the  first  New  York  Public  Service  Commission  was 
probably  responsible,  there  is  some  tendency  in  the  direction  of 
showing  those  installments  of  capital  obligation  which  mature 
within  one  year  from  the  date  of  a  given  balance  as  current 
liabilities.     Except  as  it  affects  the  current  ratio,  the  question  is 

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of  little  moment,  since  the  important  thing  is  to  have  the  amount 
of  the  indebtedness  becoming  payable  stand  out  on  the  balance 
sheet  so  that  no  one  may  look  at  that  statement  without  realizing 
that  the  necessary  cash  must  be  provided  before  the  time  indicated 
by  the  maturity.  Whether  prominence  is  given  among  the  capital 
liabilities  to  the  fact  of  the  maturity,  or  the  part  of  the  obligation 
maturing  within  the  year  is  shown  as  a  current  liability,  seems 
unimportant. 

The  protection  of  long  term  creditors  is  important,  and  any 
property  which  serves  to  secure  their  liens  must  of  course  be  kept 
in  proper  condition.  Thus  property  on  which  there  is  a  mortgage 
must  likewise  be  adequately  insured,  and  the  taxes  kept  paid  up 
on  such  property  as  is  taxable.  While  these  facts  are  not  as  a 
rule  stated  in  a  balance  sheet,  they  are  proper  questions  to  be 
asked;  and  such  information  might  well  be  incorporated  in  the 
balance  sheet  if  the  statement  is  to  answer  any  and  all  questions. 

The  fact  of  a  mortgage  may  naturally  raise  the  question  of  a 
sinking  fund.  If  such  item  appears,  the  next  point  of  information 
sought  is  whether  or  not  payments  to  the  sinking  fund  have  been 
made  in  accordance  with  the  terms  of  the  mortgage  indenture. 
The  remark  of  a  certain  well-known  accountant  who  said,  "If 
you're  going  to  tell  anything,  tell  it  all,"  applies  to  an  item  of  this 
kind  which  is  usually  thought  to  be  sufficiently  described  when 
the  account  has  been  given  a  name.  A  well  defined  tendency 
toward  writing  explanatory  captions  has  a  great  deal  of  merit. 
Such  a  caption  might  in  the  case  of  a  sinking  fund  be  made  to  tell 
the  whole  story. 

What  the  banker  refers  to  as  frozen  credits  has  its  analogy 
in  a  business  organization  when  capital  which  should  be  kept 
available  for  current  or  working  purposes  becomes  tied  up  in  fixed 
assets.  Many  a  previously  prosperous  concern  has  been  wrecked 
because  too  much  capital  was  allowed  to  get  into  plant,  and  funds 
could  not  be  found  with  which  to  meet  current  obligations.  It  is 
therefore  important  that  this  matter  be  carefully  watched.  When 
directors  see  additions  of  any  size  or  frequency  to  plant,  it  is 
proper  that  they  should  inquire  as  to  the  source  of  the  capital. 
Plant  property  is  essentially  a  capital  asset  and  is  acquired  in  the 
main  through  capital  contributions  or  capital  liabilities.  Plant 
extension  or  improvement  out  of  profits  is  a  laudable  ambition, 
but  a  procedure  attended  with  some  risk  unless  warranted  by 

2S3 


Principles  of  Accounting 

collection  efficiency  which  will  produce  the  funds  corresponding 
to  the  profits  as  appropriated  and  make  them  available  for 
conversion  into  plant.  Even  though  this  may  be  made  possible, 
there  is  always  the  question  of  maintaining  proper  relations 
between  the  fixed  and  the  liquid  assets. 

Of  the  deferred  charges  to  expense,  little  may  be  said.  They 
are  rather  generally  ignored  when  anyone  attempts  to  get  at  the 
conservative  financial  condition.  They  have  their  place  as  equal- 
izers among  periods,  but  they  receive  little  courtesy  or  considera- 
tion from  the  hard-headed  seeker  after  true  values.  Bankers 
disregard  them  with  a  contempt  marvelous  in  conception  and 
effective  in  execution.  In  other  words,  they  do  not  even  look  at 
them.  And  yet  the  accountant  goes  on  setting  them  up  and  taking 
them  seriously,  whether  they  amount  to  tens  or  thousands.  Such 
is  the  precision  of  accounting  which  attempts  to  tell  the  whole 
story,  leaving  to  the  reader  to  decide  which  parts  or  how  much 
he  will  read. 

One  class  of  items  frequently  omitted  from  balance  sheets  is 
that  of  contingent  liabilities.  These  items  are  usually  difficult  to 
show  except  as  footnotes,  and  frequently  do  not  receive  the  con- 
sideration to  which  they  are,  on  account  of  their  importance, 
entitled.  The  class  embraces  a  variety  of  items,  some  of  the  prin- 
cipal ones  being  notes,  trade  and  bank  acceptances  discounted, 
endorsements  of  notes  for  affiliated  companies,  accommodation 
endorsements,  guarantee  of  bond  interest  or  dividends  for  other 
companies,  assignment  of  accounts  receivable,  contracts  for  the 
sale  or  purchase  of  merchandise,  litigation  pending,  etc. 

There  also  arise  occasionally  instances  wherein  there  are  lia- 
bilities accruing  in  the  future  but  not  existent  at  the  date  of  the 
balance  sheet.  Such  for  example  is  a  case  where  a  substantial 
donor  to  an  educational  organization  was  to  receive  annually  in 
monthly  payments  during  the  remainder  of  her  life  a  sum  equal 
to  6%  on  the  sum  contributed.  This  liability  was  more  than  a 
contingency.  It  was  a  certainty,  but  so  long  as  paid  up  monthly 
never  constituted  a  real  liability  at  the  date  of  any  balance  sheet. 
Such  cases  may  be  shown  either  as  contras  or  as  footnotes.  The 
important  point  is  that  attention  is  drawn  to  them  in  the  balance 
sheet. 

From  the  balance  sheet  the  principal  matters  which  are 
watched  are  the  financial  strength,  the  relation  between  borrowed 

284 


Financial  Statements  as  Aids  to  Administration 

and  owned  capital,  the  liquid  condition,  the  financial  status  of 
long  term  creditors,  and  the  relation  between  fixed  and  liquid 
assets.    These  are  matters  of  interest  to  all  parties  concerned. 

The  assistance  obtained  from  the  income  statement  is  largely 
of  use  to  the  operating  officials  or  those  officers  of  administration 
who  are  responsible  for  the  profit-making.  It  is  true  that  a  study 
of  income  statements  will  give  an  idea  as  to  the  outlook,  and 
bankers  particularly  insist  on  seeing  how  the  profits  have  been 
derived;  but  operating  officials,  more  than  any  other  class,  draw 
on  the  detailed  statement  of  income  and  profit  and  loss  for  guid- 
ance in  directing  the  profit-seeking  activities  of  an  organization. 

Stress  is  laid  on  comparison,  and  in  a  way  comparison  means 
more  in  the  income  statement  than  in  the  balance  sheet.  It  has 
been  said  that  it  means  so  much  more  that  it  means  much  less; 
the  anomaly  being  due  to  the  fact  that  there  are  more  variables 
which  may  aflPect  the  comparison  of  items  in  the  income  statement 
than  in  the  balance  sheet.  For  example,  an  increase,  on  the  bal- 
ance sheet,  in  wages  accrued,  may  mean  more  employes,  higher 
wages  to  the  same  number  of  employes,  a  greater  number  of 
elapsed  days  between  the  end  of  the  pay  period  and  the  date  of 
the  balance  sheet,  or  failure  to  pay  employes  when  wages  were 
due.  The  first  three  instances  would  under  normal  conditions 
produce  an  increase  which  would  be  insignificant,  so  that  any 
substantial  increase  might  be  safely  attributed  (but  never  taken 
for  granted  where  there  is  opportunity  to  inquire)  to  slow  pay. 
On  the  other  hand,  an  increase  in  the  manufacturing  cost,  which 
might  be  shown  in  an  income  statement,  could  be  traced  perhaps 
to  any  one  of  such  causes  as  increased  material  cost,  increased 
labor  cost,  increased  overhead  expense,  decreased  production,  de- 
creased recovery  value  of  by-product,  increased  defective  work, 
etc.  An  exhaustive  study  of  the  significance  of  comparisons,  tak- 
ing the  income  statement  item  by  item,  would  no  doubt  produce 
most  interesting  results,  but  would  involve  a  tremendous  amount 
of  investigation. 

Any  discussion  of  financial  statements  as  aids  to  administra- 
tion would  not  be  complete  without  reference  at  least  to  ratios, 
which  have  become  quite  the  vogue  within  the  past  few  years.  The 
impetus  for  this  is  found  largely  in  the  research  work  which  has 
been  done  by  the  Robert  Morris  Association,  an  organization  of 
bank  credit  men.    Numerous  ratios  have  been  evolved  and  worked 

285 


Principles  of  Accounting 

up  into  a  composite  or  barometric,  the  purpose  of  which  is  to 
measure  or  test  the  risk  attaching  to  borrowers  who  make  appli- 
cations for  bank  loans  and  lines  of  credit. 

The  work  which  this  association  has  done  is  exceedingly 
meritorious,  and  those  who  are  responsible  are  entitled  to  a  great 
deal  of  credit.  It  is  work  which  accountants  should  have  done 
long  since,  and  it  therefore  little  becomes  them  to  offer  any  crit- 
icism. Hence  what  follows  should  not  be  regarded  as  criticism, 
but  rather  as  cold-blooded  discussion  based  on  certain  ratios  which 
are  included  in  the  group  evolved  by  the  bank  credit  men.  This 
group  includes :  receivables  to  merchandise,  worth  to  fixed  assets, 
sales  to  receivables,  sales  to  merchandise,  sales  to  worth,  debt 
(both  current  and  funded)  to  worth,  sales  to  fixed  assets. 

It  is  obviously  possible  to  show  the  percentage  relation  of  any 
two  figures,  regardless  of  whether  they  are  taken  from  the  balance 
sheet  or  income  statement,  or  both,  and  whether  or  not  the  fig- 
ures have  any  business  relation  or  the  result  any  significance. 
And  it  appears  that  some  of  the  ratios  before  mentioned  fall  into 
the  latter  class.  There  is  definite  relation  between  merchandise 
and  sales,  sales  and  receivables,  net  worth  and  fixed  assets,  debt 
and  net  worth.  There  is  apparently  no  relation  between  receiv- 
ables and  merchandise,  sales  and  worth,  sales  and  fixed  assets. 
Hence  it  is  difficult  to  see  how  ratios  developed  out  of  such  figures 
may  serve  as  basis  for  conclusions. 

The  ratio,  for  example,  of  receivables  to  merchandise  is  devoid 
apparently  of  any  logical  reason  for  existence.  It  does  show,  of 
course,  the  percentage  relation  of  the  two  sets  of  figures.  Sub- 
sequent ratios  may  show  increases  or  decreases,  when  compared 
with  the  first  ratio.  But  even  so,  what  does  it  signify?  Some- 
one has  argued  that  it  shows  in  a  way  the  freshness  or  quality  of 
the  receivables;  and,  again,  that  it  brings  out  a  bearing  which 
should  be  taken  into  consideration  in  looking  at  the  current  ratio. 
It  is  true,  of  course,  that  the  element  of  profit  included  in  the 
receivables  figure  without  any  corresponding  liability  has  an  effect 
on  the  current  ratio.  The  higher  the  receivables,  the  greater  the 
amount  of  profit  involved,  and  the  greater  the  effect  on  the  cur- 
rent ratio.  But  any  change  in  the  situation  is  a  simple  change, 
disclosed  better  by  a  comparison  of  receivables  than  by  a  compari- 
son of  ratios  resulting  from  dividing  the  receivables  into  the 
merchandise. 

286 


Financial  Statements  as  Aids  to  Administration 

With  regard  to  quality  this  ratio  appears  to  show  nothing. 
QuaHty  is  shown  by  dividing  the  average  monthly  sales  into  the 
receivables  and  does  not  require  a  ratio  for  the  purpose.  Or  qual- 
ity may  be  shown  through  comparative  ratios:  one,  that  of  sales 
to  receivables;  the  other,  based  on  the  terms  of  credit.  For  ex- 
ample, if  the  credit  term  is  sixty  days,  at  any  time  not  more  than 
17%  of  the  amount  corresponding  to  sales  should  remain  uncol- 
lected. As  the  ratio  of  the  sales  to  receivables  compares  with 
17%,  so  is  the  freshness  or  the  quality  of  the  receivables  indicated. 
While  quality  is  essential  to  a  composite  measurement  of  credit 
risk,  it  seems  to  be  covered  in  the  sales  to  receivables  ratio. 

Any  attempt  to  get  at  turnover  of  capital  through  a  ratio  of 
sales  to  worth  fails  because  only  a  portion  of  the  free  or  owned 
capital  is  invested  in  goods  which  are  the  subject  of  sale.  Strictly 
speaking,  only  that  capital  which  is  invested  in  goods  should  be 
used  for  such  calculation.  It,  therefore,  seems  more  accurate  to 
use  for  turnover  purposes  the  average  investment  in  goods  and 
the  cost  of  sales,  dividing  the  former  into  the  latter  in  order  to 
ascertain  the  number  of  times  capital  invested  in  stock  in  trade 
has  been  turned  over.  This  method  excludes  the  element  of  profit 
and  produces  a  result  which  is  at  once  clear  and  susceptible  of 
only  one  interpretation. 

The  idea  of  ratios  is  an  excellent  one  and  the  information  which 
they  give  when  properly  used  is  exceedingly  valuable.  Like  many 
other  good  things  they  should  not  be  overworked,  and  particularly 
when  the  results  are  without  significance. 

The  future  development  of  financial  statements  will  probably 
see  the  major  exhibits  generously  supplemented  by  supporting 
schedules  of  detail  and  statistics.  The  generalities  of  the  main 
statements  show  indications  and  tendencies,  but  the  specific  infor- 
mation necessary  to  action  is  usually  found  in  the  underlying 
details.  There  is  much  opportunity  for  development  and  improve- 
ment in  the  art  of  interpreting  financial  statements. 


2^7 


APPENDIX 

CAPITAL   STOCK    WITHOUT    PAR  VALUE 

The  original  purpose  back  of  the  law  providing  for  issue  of 
stock  without  par  value  seems  to  have  been  to  remove  any  expres- 
sion or  impression  of  a  fixed  value  attaching  to  such  shares; 
this  for  such  benefit  or  effect  as  it  might  have  in  the  affairs  of 
corporations  and  their  relations  with  those  who  contribute  capital 
to  corporate  enterprises. 

A  note  of  paternalism  is  sounded  by  some  writers  who,  in 
attempting  to  explain  the  reasons  for  the  law,  credit  the  law- 
makers with  a  desire  to  protect  the  investor  who  buys  a  share  of 
stock  at  a  fixed  price  of  $ioo  and  looks  upon  the  disbursement 
as  a  loan  to  a  corporation  which  amount  he  expects  to  be  able 
to  recover  whenever  he  so  desires. 

Whether  or  not  this  somewhat  laudable  motive  was  in  the 

mind  of  the  law-framer  may  never  be  known,  but  the  effect  of 

^he  law  is  to  stamp  the  transaction  as  a  proprietary  venture  and 

so  far  as  it  concerns  the  investor  to  put  him  on  notice  to  inquire 

as  to  the  value  of  his  share. 

The  law  has  a  distinct  advantage  for  directors  who  desire  to 
be  honest  and  straightforward  since  it  relieves  them  of  the  neces- 
sity of  becoming  parties  to  a  fiction  which  has  often  been  mis- 
leading. This  fiction  has  in  the  past  been  particularly  true  in 
cases  involving  patents,  copyrights,  good-will,  contracts,  mines, 
etc.,  where  there  is  usually  more  or  less  difficulty  in  fixing  the 
value  of  such  acquisitions. 

Under  a  law  providing  for  common  stock  without  par  value, 
the  situation  and  procedure  appear  immediately  to  be  much  simpli- 
fied. The  common  shareholder,  regardless  of  what  he  may  have 
paid  for  his  stock,  becomes  entitled  to  such  proportion  of  the  net 
/  assets,  after  deducting  the  value  of  any  preferred  shares  out- 
standing, as  the  number  of  his  shares  bears  to  the  total  number 
of  common  shares  outstanding.  The  aggregate  value,  or  the 
equity  of  the  common  shareholders,  is  determined  by  the  excess 
of  assets  over  liabilities  and  preferred  shares.  The  value  per 
share  obviously  is  determined  by  dividing  the  number  of  com- 
mon shares  outstanding  into  such  excess. 

As  profits  are  derived  from  operation,  or  assets  otherwise 

288 


Capital  Stock  without  Par  Value 

increase  in  value,  without  increase  in  liabilities  or  preferred 
capital,  so,  subject  to  distribution  of  dividends  to  either  preferred 
or  common  shareholders,  the  equity  and  corresponding  value  of 
the  common  shares  increase.  When  losses  are  sustained,  there 
are  shrinkages  of  asset  values,  or  increases  in  liabilities  without 
corresponding  increases  in  assets,  the  value  of  the  common  shares 
diminishes. 

The  prospective  purchaser  of  common  shares  is,  therefore, 
charged  with  investigation  and  his  attention  is  naturally  directed 
to  the  balance  sheet  which  is  presumed  to  supply  the  information 
necessary  to  enable  him  to  ascertain  the  value  of  the  shares. 
While  it  may  be  true  that  the  market  price  of  the  shares  is 
indicative  of  their  value,  this  obviously  may  not  be  taken  as  a 
true  index  thereof  since  there  are  many  outside  influences  bearing 
on  the  market  quotations.  For  example,  the  net  asset  value  per 
share  of  United  States  Rubber  Company  common  stock,  accord- 
ing to  the  published  balance  sheet  of  December  31,  1920,  was 
$166.70;  yet  on  the  same  date  the  common  stock  sold  at  66 J^. 
This  asset  value  was  after  the  deduction  of  liberal  reserves,  includ- 
ing dividends  payable  a  month  later,  and  would  undoubtedly  have 
a  strong  bearing  on  the  consideration  of  the  stock  by  a  prospec- 
tive speculative  investor,  although  ignored  by  a  purchaser  who 
might  desire  the  stock  for  use  as  collateral. 

The  argument  may  be  advanced  that  it  is  frequently  difficult 
to  obtain  balance  sheets  sufficiently  recent  to  be  of  practical  value 
in  this  respect  and  that  brokers  are  not  interested  in  supplying 
such  statements  for  the  convenience  of  prospective  purchasers. 
It  neverthelesw  appears  that  if  the  buyer  of  stocks  is  to  exercise 
intelligent  judgment  in  so  doing,  he  will  naturally  turn  to  the 
balance  sheet  as  a  means  of  information  regarding  the  asset  value 
of  the  stock.  Increasing  demand  of  such  character  cannot  but 
help,  it  seems,  to  exert  an  influence  on  corporations  which  will 
tend  to  make  them  bring  out  their  balance  sheets  more  frequently 
than  at  present.  This  should  be  especially  true  of  those  which 
depend  or  pride  themselves  upon  a  wide  distribution  of  stock 
in  the  hands  of  the  general  public. 

The  effect  of  non-par  value  common  stock  laws  upon  the 
policies  of  directors  should  be  wholesome  in  many  respects. 
Because  previous  laws  made  shares  of  stock  which  were  issued 
for  less  than  their  par  value  partially  paid  and  therefore  assessable 

289 


Principles  of  Accounting 

for  the  difference,  it  was  quite  customary  for  companies  acquiring 
patents,  copyrights,  good-will,  etc.,  to  fix  the  value  of  such  acquisi- 
tions at  the  par  value  of  the  stock  issued  in  exchange  therefor. 
This,  while  entirely  legal,  provided  the  directors  declared  that 
the  value  fixed  was  in  their  judgment  correct  and  there  was  no 
fraud  involved,  led  to  what  amounted  to  an  admission,  sometimes 
almost  in  the  same  breath,  that  the  assets  were  not  worth  what 
they  were  declared  to  be  worth  by  accepting  from  the  recipients 
of  the  stock  a  donation  of  a  large  block  thereof,  for  the  purpose 
of  providing  working  capital.  After  going  through  such  legal 
formality,  the  stock  could  be  sold  at  any  price  or  if  desired  given 
away.  In  many  instances,  it  was  given  away  as  a  bonus  to  induce 
the  purchase  of  preferred  shares. 

This  resulted  in  a  long  and  involved  series  of  entries  setting 
up  the  assets  acquired  and  the  stock  outstanding  at  fictitious 
values;  creating  a  treasury  stock  account  at  an  inflated  value, 
with  an  off-setting  account,  in  order  to  keep  the  books  in  balance, 
designated  by  some  such  title  as  "Stock  donation  account."  This 
was  followed  by  certain  adjusting  entries  as  the  stock  was  sold, 
writing  off  the  discount  from  the  par  value  against  the  stock 
donation  account  and  finally  transferring  the  balance  to  a  surplus 
account. 

Much  annoyance  and  controversy  was  occasioned  by  this  dis- 
position of  the  balance  in  the  stock  donation  account.  Some 
contended  that  it  should  be  closed  into  a  restricted  surplus  account 
and  made  a  part  of  the  invested  capital.  Others  insisted,  and 
with  the  support  of  court  decisions,  it  must  be  admitted,  that  it 
should  become  a  part  of  the  free  surplus,  thus  being  susceptible 
to  distribution  as  dividends.  The  former  disposition  undoubtedly 
carried  out  the  intention  of  the  stock  donors.  The  latter  just  as 
surely  defeated  the  purpose  for  which  the  donation  was  intended. 

The  present  non-par  value  laws,  generally  speaking,  make  it 
possible  for  the  directors  to  act  in  a  manner  which  is  at  once 
clean-cut  and  frank.  Twenty-three  states  have  passed  laws  pro- 
viding for  the  issue  of  common  stock  without  par  value.  Most 
of  the  laws  provide  that  the  stock  may  be  issued  for  such  con- 
sideration as  is  fixed  by  the  directors  acting  under  authority  of 
the  certificate  of  incorporation  or  power  conferred  upon  them  by 
the  stockholders. 

The  Illinois  law  is  an  exception  to  this  rule  in  that  non-par 

290 


Capital  Stock  without  Par  Value 

value  stock  may  not  be  issued  for  less  than  five  dollars  a  share. 
In  the  Maine  law  there  is  apparently  a  conflict ;  one  section  author- 
izing the  stock  to  be  issued  for  such  consideration  as  the  cer- 
tificate, etc.,  may  provide;  another  section  stipulating  that  the 
non-par  stock  must  have  a  value  of  at  least  five  dollars  a  share. 

The  New  York  law  previously  placed  a  minimum  limitation 
of  five  dollars  per  share  on  non-par  stock,  but  in  the  latest  amend- 
ment, effective  May  ii,  1921,  an  alternative  proviso  is  included 
so  that  by  making  the  necessary  statement  in  the  certificate  of 
incorporation,  the  limitation  as  to  the  value  of  the  non-par  stock 
is  removed  and  the  stock  may  be  issued  for  such  consideration 
as  may  be  fixed  by  the  directors. 

Under  the  present  laws,  except  in  those  states  where  a  min- 
imum value  is  required  to  be  placed  on  the  non-par  stock,  the 
issue  of  such  stock  for  patents,  trade-marks,  and  like  acquisitions 
is  much  simplified  and  the  facts  are  clearly  reflected  in  the  account- 
ing. The  true  value,  or  at  least  the  value  which  represents  the 
best  judgment  of  the  directors  is  assigned  to  the  asset  acquired. 
This  amount  represents  the  value  of  the  common  stock  issued 
in  exchange  for  the  asset  and  is  the  amount  which  is  credited 
to  the  common  capital  stock  account.  Should  any  of  such  com- 
mon shares  then  be  donated  by  the  recipient  thereof,  no  money 
entry  is  required;  a  memorandum  entry  in  a  treasury  stock 
account  showing  the  number  of  shares,  without  value  attaching, 
being  sufficient.  Upon  the  subsequent  sale  of  any  of  this  stock, 
cash  in  the  amount  of  the  proceeds  would  be  debited  and  the 
common  capital  stock  account  credited.  Thus  are  the  facts 
recorded  and  the  troublesome  entries  in  the  stock  donation  account 
made  unnecessary.  There  is  also  avoided  any  question  of  dis- 
position of  the  balance  in  the  stock  donation  account  as  to  whether 
it  should  be  transferred  to  the  free  or  the  restricted  surplus. 
The  value  of  the  common  stock  is  represented  by  the  value  of 
the  patents  or  other  intangible  assets  acquired,  plus  the  cash 
received. 

Several  states,  for  example.  New  York,  New  Jersey,  Pennsyl- 
vania, Massachusetts,  and  Illinois,  among  others,  have  complicated 
the  situation  with  regard  to  stock  without  par  value  by  providing 
that  both  preferred  and  common  shares  may  be  issued.  Some 
states  also  authorize  a  division  of  the  common  stock  into  two  or 

291 


Principles  of  Accounting 

more  classes.  The  purpose  of  the  latter  provision  seems  solely  to 
differentiate  stockholders  as  to  voting  power. 

Where  there  are  both  preferred  and  common  shares  without 
par  value,  the  former  may  carry  a  preference  either  as  to  dividends 
or  assets,  or  both.  Where  preferred  as  to  assets,  the  amount  of 
such  preference  must  be  expressed  in  the  certificate  and 
presumably  may  not  be  greater  than  the  amount  paid  in  for  the 
preferred  stock. 

Under  the  New  Jersey  law,  the  total  number  of  preferred 
shares  both  with  and  without  par  value  issued  and  outstanding 
may  never  exceed  two-thirds  of  the  entire  number  of  shares  of  all 
classes  issued  and  outstanding.  Any  preferred  stock  without  par 
value  may  be  redeemed  after  three  years  from  date  of  issue  at  the 
price  which  the  corporation  received  for  the  stock  when  issued. 

A  share  of  preferred  stock  without  par  value  is  represented 
by  a  certificate  setting  forth  that  the  party  whose  name  appears 
thereon  has  contributed  a  certain  amount  expressed  therein  to 
the  capital  fund  of  the  corporation  issuing  the  certificate  and  is 
entitled  to  the  return  of  the  sum  specified  before  any  capital 
funds  are  returned  to  common  shareholders. 

The  only  advantage  of  preferred  stock  without  par  value 
/.-'seems  to  be  that  of  making  it  possible  to  sell  such  stock  at  any 
price  upon  which  the  directors  may  agree  and  still  have  such  stock 
full-paid  and  non-assessable. 

The  provision  has  the  disadvantage  of  raising  certain  questions 
in  the  mind  of  anyone  familiar  with  the  theory  underlying  common 
stock  without  par  value  as  to  the  rights  of  the  respective  classes 
of  shareholders,  and  lays  the  foundation  for  involved  controversy, 
if  not  litigation.  For  example,  granting  that  in  liquidation  the 
rights  of  the  preferred  shareholders  rank  ahead  of  those  of  the 
common  shareholders,  what  would  be  the  preferences,  as  among 
them,  of  preferred  shareholders  who  had  purchased  shares  at 
$60,  $70  and  $80  respectively  ? 

The  certificate  of  the  common  shareholder  differs  in  substance 
in  that  it  entitles  him  upon  distribution,  and  regardless  of  what 
he  may  have  paid  for  his  stock,  to  an  aliquot  part,  according  to  the 
number  of  shares  outstanding  at  such  time,  of  the  net  assets  over 
and  above  all  debts  and  stock  preferences. 

While  the  common  shares  may  have  been  sold  at  various 
prices,  the  respective  holders  are  all  placed  on  the  same  footing 

292 


Capital  Stock  without  Par  Value 

in  the  matter  of  distribution  of  assets.  Thus  is  the  apportionment 
to  them  made  easy  whereas  the  distribution  to  preferred  share- 
holders, where  stock  has  been  sold  at  different  prices,  would 
appear  to  be  attended  with  considerable  difficulty.  The  provision 
for  non-par  value  preferred  stock  is  so  comparatively  recent  that 
actual  cases  have,  so  far  as  is  known,  yet  to  be  settled.  The 
possibilities  of  difficulty  in  fixing  the  order  and  amount  of 
payment  to  such  shareholders,  however,  are  easy  to  foresee. 

Another  interesting  point  involved  in  the  question  of  stock 
without  par  value  is  the  stated  capital.  In  this  connection,  it 
is  perhaps  pertinent  to  consider  the  purpose  of  the  provision  in 
the  law  such  as  has  been  made  in  the  case  of  Maine,  and  as  an 
alternative  provision  in  New  York. 

Stated  capital  does  not  mean  the  capital  with  which  the 
corporation  will  begin  business,  such  as  $500  or  $1,000,  but  the 
capital  with  which  the  corporation  will  carry  on  business.  The 
Maine  law,  for  example,  requires  that  the  certificate  of  incorpora- 
tion shall  state — "the  amount  of  capital  with  which  the  corporation 
will  carry  on  business,  which  amount  shall  not  be  less  than  the 
amount  of  the  preferred  stock,  if  any,  authorized  to  be  issued 
with  a  preference  as  to  principal,  and  in  addition  thereto  a  sum 
equivalent  to  five  dollars,  or  to  some  multiple  of  five  dollars,  for 
every  share  authorized  to  be  issued  other  than  the  preferred  stock ; 
but  in  no  event  shall  the  amount  of  such  capital  be  less  than  one 
thousand  dollars." 

The  provision  of  the  New  York  law  is  substantially  the  same 
except  that  instead  of  stock  "authorized"  the  law  reads  "stock 
issued  and  outstanding" ;  there  is  no  minimum  limitation  as  to  the 
amount;  and  the  original  amount  may  be  increased  by  "such 
additional  amount  as  from  time  to  time  may  by  resolution  of  the 
board  of  directors  of  the  corporation  be  transferred  thereto." 

The  Maine  law  in  respect  to  stated  capital  appears  to  present 
certain  difficulties  in  that  stock  authorized  may  be  very  different 
in  amount  from  stock  issued  and  outstanding,  and  it  would  be 
impossible  as  a  practical  matter  to  carry  on  business  with  capital 
representing  stock  until  such  stock  has  been  sold  and  the  capital 
realized. 

The  purpose  underlying  the  requirement  as  to  stated  capital 
is  apparently  two-fold;  first,  to  distinguish  from  paid  in,  or 
contributed   capital,   that  derived   from  operations;   second,   to 

293 


Principles  of  Accounting 

'aisclose  to  those  from  whom  the  corporation  may  seek  credit, 
the  fact  that  there  is  a  margin  over  and  above  the  liabilities,  which 
is  not  subject  to  distribution  as  dividends,  and  upon  which  reliance 
may  be  placed  for  safety  in  granting  credit. 

Without  the  requirement  of  stated  capital,  the  division  between 
contributed  and  earned  capital  is  lost  as  soon  as  any  accretions 
are  derived  from  operations.  Where  non-par  common  shares 
are  involved  any  surplus  automatically  disappears  through  merger 
with  the  common  capital  since  the  common  shareholders  become 
entitled  to  whatever  excess  there  may  be  of  net  assets  over  any 
preferences.  Unless  some  legal  provision  is  made  for  setting 
apart  the  contributed  capital,  the  matter  of  distinguishing  it  from 
the  earned  surplus  is  apparently  left  to  the  pleasure  of  the 
directors  or  the  accounting  officials. 

Good  accounting  naturally  dictates  that  the  surplus  resulting 
from  operations  shall  be  kept  and  shown  as  an  account  and 
item  separate  from  the  contributed  capital,  but  unless  the  law 
specifies  that  the  capital  with  which  the  corporation  will  carry  on 
business  shall  be  stated,  there  appears  to  be  no  means  of  imposing 
this  separation. 

Merging  the  surplus  from  operations  with  contributed  capital 
is  dangerous  in  at  least  two  respects.  Capital  contributed  may  be 
impaired,  and  the  impairment  concealed  as  to  the  balance  sheet, 
when  a  deficit  from  operations  exceeds  the  previous  accumulation 
of  surplus.  Dividends  may  unwittingly  be  paid  out  of  capital 
where  the  amount  of  the  dividend  declared  exceeds  the  accumu- 
lation of  surplus.    The  first  is  misleading;  the  second,  illegal. 

Where  the  question  of  a  change  in  the  form  of  stock  incident 
to  reorganization  enters  into  the  situation,  some  modification  of 
the  above  views  may  be  indicated.  And  the  decision  depends 
largely  upon  the  meaning  of  reorganization.  Where  reorganiza- 
tion means  merely  a  change  in  the  form  of  capital  stock  from  that 
with  a  par  value  to  that  without  par  value,  there  appears  to  be 
no  reason  for  combining  the  surplus  with  the  capital  unless  such 
procedure  is  made  necessary  by  the  statement  of  capital. 

If  a  corporation  with  a  capital  of  $100,000  represented  by 
capital  stock  with  par  value  and  with  a  surplus  of  $150,000  were 
to  change  to  capital  stock  without  par  value  and  announce  that 
henceforth  the  corporation  would  carry  on  business  with  a  stated 
capital  of  $200,000,   it  would  seem  only  logical  that  $100,000 

294 


Capital  Stock  without  Par  Value 

should  be  transferred  from  surplus  to  capital.  But  as  long  as  tlie 
stated  capital  is  not  in  excess  of  $100,000,  the  transfer  of  the 
surplus,  or  the  combination  of  capital  and  surplus,  seems  an 
unnecessary  step  which  only  works  a  disadvantage  in  tying  up 
the  surplus. 

If,  however,  reorganization  means  the  creation  of  a  new  legal 
entity,  there  is  some  question  regarding  the  propriety  of  not 
merging  the  surplus  and  capital  of  the  predecessor  corporation 
and  having  the  combined  amount  appear  as  capital  on  the  books 
of  the  successor  corporation.  The  contention  is  frequently  made, 
and  with  some  basis  of  logic,  that  newly  organized  corporations, 
except  certain  classes  where  surplus  has  been  paid  in,  can  have 
no  surplus  prior  to  operations.  It  is  also  contended,  following 
out  this  line  of  argument,  that  a  corporation  may  not  purchase 
surplus.  In  the  case  of  merger,  the  surplus  of  the  two  corpora- 
tions may  be  combined  after  all  the  capital  stock  of  one  corpora- 
tion has  been  acquired  by  the  other,  but  when  purchasing  or 
acquiring  the  stock  the  acquiring  corporation  is  in  reality  acquir- 
ing the  net  assets.  And  it  is  contended  by  those  who  hold  this 
view  that  the  net  assets  are  not  divisible  into  the  equities  of 
capital  and  surplus.  It  is  doubtful  if  such  contention  could  be 
maintained,  however,  in  one  case  where  a  corporation  purchased 
the  capital  stock  of  another  corporation,  the  balance  sheet  of 
the  latter  showing  a  surplus  was  copied  into  and  made  a  part 
of  the  certificate  of  incorporation. 

It  is  probably  more  conservative  and  better  accounting  gen- 
erally, where  a  new  corporation  having  common  capital  stock 
without  par  value  takes  over  a  predecessor  corporation  having 
capital  stock  with  par  value,  to  take  the  position  that  the  net 
assets  have  been  acquired  and  set  up  the  capital  of  the  new  cor- 
poration In  an  amount  equal  to  the  value  of  the  net  assets,  ignor- 
ing any  question  of  surplus. 

The  act  of  changing  from  stock  with  par  value  to  stock  without 
par  value  raises  a  question  with  regard  to  the  treatment  of  surplus. 
The  treatment  in  turn  depends  upon  the  procedure  by  which  the 
change  is  accomplished.  One  method  of  procedure  consists  merely 
in  changing  the  form  of  stock.  The  other  method  consists  in 
organizing  a  new  corporation  and  introducing  the  new  form  of 
stock.  It  IS  not  the  intention  to  discuss  here  the  relative  advan- 
tages and  disadvantages  of  the  two  methods ;  rather  the  effect  of 

295 


Principles  of  Accounting 

the  respective  methods  on  the  surplus.  Both  methods  are  some- 
what carelessly  referred  to  as  reorganization.  The  word  is  a 
misnomer  in  the  first  instance,  wherein  no  reorganization  takes 
place.  The  only  thing  which  happens  in  that  case  is  a  change  in 
the  form  of  capital  stock.  Reorganization  may  be  said  to  take 
place  only  where  a  new  corporation  is  organized  to  succeed  a 
former  corporation. 

As  illustrating  a  case  wherein  the  capital  stock  is  changed 
in  form,  assume  that  at  a  given  date  the  Burrington  Company 
(a  New  York  corporation)  had  assets  of  $500,000,  liabilities  of 
$100,000,  capital  stock  of  $250,000  (2,500  shares  of  $100  each) 
and  earned  surplus  of  $150,000.  It  is  then  decided  to  change  the 
form  of  stock  from  that  with  par  value  to  that  without  par  value. 

The  fact  is  obvious  that  no  changes  have  occurred  in  the  assets, 
the  liabilities,  the  capital,  or  the  surplus.  The  only  possibility 
is  that  the  situation  may  have  been  affected  by  the  amended 
certificate  of  incorporation  which  would  have  to  be  filed.  This 
document  is  referred  to  in  the  New  York  law  as  the  "certificate  of 
reorganization,"  although  paragraph  24  following  states  that 
such  proceedings  shall  not  be  "deemed  to  work  a  dissolution,  or  to 
create  a  new  corporation  or  to  interrupt  in  any  way  the  continuity 
of  existence  of  the  corporation  affected.'* 

Irrespective  of  this  misnomer  the  requirement  of  the  statute 
imposes  upon  the  corporation  a  necessity  for  showing  in  the 
certificate  of  reorganization  the  amount  of  capital  with  which  the 
corporation  will  carry  on  business.  This  is  known  as  the  stated 
capital.  The  New  York  law  with  respect  to  this  matter  makes 
alternative  provisions.  The  stated  capital  may  be  either  an 
amount  not  less  than  five  dollars  a  share  for  each  share  of  stock 
without  par  value  or  the  aggregate  of  the  amounts  received  for 
the  stock.  Where  the  corporation  has  also  an  issue  of  stock  with 
par  value,  such  as  preferred,  the  par  value  of  such  shares,  issued 
and  outstanding,  must  be  included  in  the  stated  capital.  The 
amount  of  stated  capital  may  by  resolution  of  the  directors  be 
increased  but  no  provision  seems  to  be  made  that  it  may  be 
decreased. 

Thus  it  appears  in  the  case  under  consideration  that  it  would 
lie  within  the  power  of  the  directors  to  fix  the  stated  capital  at 
almost  any  figure  not  in  excess  of  $400,000.  If  the  maximum 
amount  were  taken  it  would  require  that  the  surplus  be  trans- 

296 


Capital  Stock  without  Par  Value 

ferred  to  the  capital  account  and  would  no  longer  be  available  for 
dividends.  Any  dividend  declared  under  such  circumstances 
before  further  profits  were  earned  obviously  would  be  declared 
out  of  capital  in  violation  of  section  20,  paragraph  2,  of  the  New 
York  Stock  Corporation  Law,  as  follows : 

"No  corporation  shall  declare  any  dividend  which  shall  reduce 
the  amount  of  its  capital  below  the  amount  stated  in  the  certificate 
as  the  amount  of  capital  with  which  the  corporation  shall  carry 
on  business." 

With  such  a  barrier  it  would  seem  foolhardy  for  a  corporation 
to  take  steps  whereby  it  would  be  prevented  from  falling  back 
on  the  surplus  should  occasion  arise.  The  corporation  is  not 
required  to  close  out  its  surplus  to  the  capital  account.  There 
is  nothing  in  the  law  which  requires  that  the  amount  of  capital 
shall  be  greater  than  it  was  before  the  change  in  the  form  of 
capital  stock  took  place.  Suggestions  to  designate  the  surplus 
as  capital  or  special  surplus  seem  inappropriate.  There  is  appar- 
ently no  reason  why  the  surplus  should  not  be  left  free  and  dis- 
tributable if  desired  so  long  as  distributions  do  not  encroach  on 
the  stated  capital. 

Where  reorganization  means  effecting  a  new  corporation,  at 
the  same  time  changing  the  form  of  capital  stock,  the  situation 
appears  to  be  entirely  different.  The  opinion  of  many  accountants 
is  that  there  is  no  question  of  surplus  involved.  A  newly  organ- 
ized corporation  ordinarily  has  no  surplus. 

Ordinarily  a  successor  corporation  acquires  the  net  assets 
of  the  predecessor  corporation.  The  value  of  the  net  assets  auto- 
matically fixes  the  amount  of  capital  of  the  successor  corporation. 
The  capital  value  per  share  is  determined  by  dividing  the  number 
of  shares  without  par  value  into  the  amount  of  capital. 

It  is  possible,  of  course,  under  the  New  York  law,  for  the 
stated  capital  to  be  fixed  at  an  amount  less  than  the  value  of  the 
net  assets  acquired.  If  the  stated  capital  were  to  be  so  fixed  the 
difference  between  the  net  asset  value  and  stated  capital  naturally 
would  have  to  be  designated  as  surplus.  This  in  fact  would  be 
capital  surplus  or  surplus  arbitrarily  taken  from  the  capital.  It 
does  not  seem  feasible  to  trace  it  back  to  its  origin  in  the  prede- 
cessor company  ^nd  determine  whether  it  was  derived  from 
earnings  or  capital.    By  reason  of  the  philosophy  which  regards 

297 


Principles  of  Accounting 

the  net  asset  value  of  the  old  corporation  as  the  capital  of  the  new 
corporation,  it  must  be  considered  as  capital. 

Under  such  circumstances  there  appears  to  be  little  doubt  that 
the  surplus  should  be  properly  ear-marked  as  capital  surplus  and 
not  made  available  for  dividends.  The  courts  possibly  would  not 
uphold  such  position,  yet  good  accounting  practice  demands  such 
procedure.  There  is  apparently  no  reason  for  setting  up  such  a 
surplus  account  except  to  make  the  capital  account  coincide  with 
the  amount  of  stated  capital  set  forth  in  the  certificate.  There 
is  apparently  nothing  gained  by  so  doing.  It  would  probably  be 
better  to  leave  the  whole  amount  representing  the  net  asset  value 
in  the  capital  account,  even  though  a  balance  sheet  would  show 
capital  in  excess  of  that  stated  in  the  certificate. 

Experience  in  dealing  with  questions  relating  to  stock  without 
par  value  demonstrates  the  necessity  of  ascertaining  the  state  in 
which  the  corporation  is  chartered  and  consulting  the  law  of  such 
state  before  attempting  to  give  an  answer  to  any  question.  Pro- 
cedure which  is  entirely  proper  and  legal  in  one  state  may  be  just 
the  reverse  in  another.  What  may  seem  possible  under  one  sec- 
tion of  a  given  law  may  be  proscribed  by  another. 

A  corporation  organized  under  the  laws  of  the  State  of 
Delaware  and  having  only  common  stock  without  par  value  sold 
all  of  its  stock  except  that  issued  for  property  at  $20  a  share, 
less  certain  commissions  to  the  syndicate  managers.  Because 
the  certificate  of  incorporation  stipulated  that  no  stock  should  be 
sold  at  less  than  $10  a  share,  the  official  in  charge  of  the  accounting 
caused  $10  per  share  to  be  credited  to  the  common  capital  account 
while  the  balance  was  credited  to  a  capital  surplus  account. 

The  question  which  arose  in  this  case  at  a  later  date  was 
whether  or  not  the  corporation  might  pay  a  dividend  out  of  the 
capital  surplus,  or  out  of  the  earned  surplus  to  which  the  capital 
surplus  had  first  been  transferred. 

At  first  glance  It  might  appear  entirely  possible,  without  coming 
into  conflict  with  the  law,  to  use  any  surplus  for  purposes  of 
dividends.  The  Delaware  law  places  no  restriction  on  the  amount 
of  capital.  There  is  no  statement  required  as  to  the  amount  of 
capital  with  which  the  corporation  will  carry  on  business.  The 
Delaware  law  is  extremely  liberal  as  to  corporations  having 
shares  without  par  value.    About  the  only  restriction  imposed  is 

298 


Capital  Stock  without  Par  Value 

that  the  corporation  may  not  commence  business  with  less  than 
ten  shares. 

But  the  law  does  say  that  "the  directors  .  .  .  shall  have  power 
after  reserving  over  and  above  its  capital  stock  paid  in,  such 
sum,  if  any,  as  shall  have  been  fixed  by  the  stockholders,  to  declare 
a  dividend  among  its  stockholders  of  the  whole  of  its  accumulated 
profits,  in  excess  of  the  amount,  so  reserved,  and  pay  the  same  to 
such  stockholders  on  demand ;  provided,  that  the  corporation  may, 
in  its  certificate  of  incorporation,  or  in  its  by-laws,  give  the 
directors  power  to  fix  the  amount  to  be  reserved." 

The  law  further  states  that  "No  corporation  created  under  the 
provisions  of  this  chapter,  nor  the  directors  thereof,  shall  make 
dividends,  except  from  surplus  or  net  profits.  Dividends  may  be 
paid  in  cash  or  capital  stock  at  par,  or  in  the  case  of  stock  without 
par  value,  dividends  in  capital  stock  may  be  paid  at  a  price  fixed 
by  the  board  of  directors,  but  otherwise  the  corporation  shall  not 
divide,  or  in  any  way  pay  to  the  stockholders,  or  any  of  them,  any 
part  of  its  capital  stock." 

While  the  courts  seem  to  have  been  liberal  in  defining  surplus 
profits  it  is  doubtful  if  in  the  instance  above  mentioned,  any  court 
would  have  construed  any  part  of  the  money  paid  in  for  capital 
stock  as  surplus.  In  the  case  of  Williams  vs.  Western  Union 
Telegraph  Company  (93  N.  Y.,  162)  the  court  defined  surplus 
as  being  the  excess  of  assets  over  liabilities  and  capital.  But  it 
seems  doubtful  if  any  court  would  regard  the  money  received  in 
exchange  for  capital  stock  as  anything  but  capital. 

The  surplus  created  in  the  Delaware  case  was  different  from 
that  which  might  arise  from  revaluation  of  assets.  It  was  different 
from  that  which  might  be  created  where  stock  with  par  value  is 
involved  and  the  stock  is  sold  at  a  premium.  It  appears  that  the 
action  was  nothing  more  than  an  arbitrary  division  of  the  capital 
resulting  from  the  sale  of  stock  into  two  parts,  one  called  capital, 
the  other,  surplus.  It  would  therefore  appear  that  a  payment  of 
dividends  out  of  such  surplus  would  be  illegal. 

Cases  presenting  complicated  problems  under  the  laws  govern- 
ing the  issue  of  stock  without  par  value  are  already  arising  with 
some  frequency.  The  prospect  for  interesting  litigation  growing 
out  of  such  cases  is  excellent.  The  law-makers,  in  endeavoring  to 
remove  existing  opportunities  for  abuse,  presumably  thought  to 
take  a  forward  step  when  they  introduced  the  first  law  bearing  on 

299 


Principles  of  Accounting 

common  stock  without  par  value.  They  added  immeasurable 
opportunity  for  involvement,  probably  unwittingly,  when  they 
went  a  step  further  and  made  similar  provision  for  preferred 
stock. 

Preferred  stock  without  par  value  is  aiready  on  the  market. 
The  certificates,  in  the  case  of  one  corporation,  are  numbered  and 
show  the  number  of  shares  which  they  represent,  as  usual.  There 
is  no  reference  to  the  amount  for  which  they  were  exchanged 
when  issued.  How  the  purchaser  of  shares  from  any  holder  other 
than  the  issuing  company  can  tell  whether  he  is  buying  something 
worth  ninety-five  dollars  or  fifteen  cents,  is  a  problem.  How  a 
quotation  is  to  be  established  is  equally  baffling.  The  company 
may  know  how  much  was  received  from  the  sales  of  such  stock, 
but  how  is  the  subsequent  purchaser  to  determine  unless  the 
paid-in  value  or  the  redemption  value  is  endorsed  on  the  stock 
certificates  ?  And  how  is  the  transfer  to  be  accomplished  except 
the  paid-in  value  or  redeemable  value  is  endorsed  on  the  stock 
certificates?  How,  when  shares  of  preferred  stock  are  issued 
originally  at  dififerent  rates  and  afterward  merged  into  a  block 
covered  by  one  certificate  later  to  be  sub-divided,  is  the  recipient 
of  part  of  the  shares  to  know  what  is  the  value  of  his  equity,  unless 
the  certificates  carry  values  ? 

It  is  to  be  presumed  that  any  corporation  issuing  shares  of 
preferred  stock  without  par  value  at  different  rates  will  either 
identify  the  various  issues  by  serial  letters,  ear-mark  the  stock  by 
endorsing  upon  it  the  amount  received  in  exchange  therefor,  or 
place  upon  it  a  redeemable  value. 

One  company  has  already  issued  preferred  stock  without  par 
value,  placed  a  value  upon  it  of  one  hundred  dollars  per  share, 
and  agreed  to  redeem  it  at  that  figure.  The  question  which 
naturally  arises  is,  "Wherein  then  lies  the  advantage  of  having 
preferred  stock  without  par  value  ?"  The  answer  probably  is  that 
such  stock  may  be  issued  at  any  price  which  may  please  the 
company,  without  rendering  the  holders  liable  for  assessment  as 
would  be  the  case  were  preferred  stock  with  par  value  to  be 
issued  at  some  lower  figure.  In  this  case  it  seems  apparent  that 
the  company  recognized  the  necessity  which  in  New  York  the 
statutes  impose,  of  fixing  a.  redeemable  value  for  the  preferred 
stock  in  order  to  establish  the  equity  of  the  preferred  shareholders. 
The  New  York  law  provides  that  "The  certificates  for  preferred 

300 


Capital  Stock  without  Par  Value 

shares  shall  state  the  amount,  if  any,  which  the  holders  of  each 
of  such  preferred  shares  shall  be  entitled  to  receive  on  account 
of  principal  from  the  assets  of  the  corporation  in  preference  to 
the  holders  of  other  shares.  .  .  ." 

But  assume  that  the  company  later  needs  more  capital ;  common 
stock  is  not  sufficiently  attractive  to  find  ready  sale,  and  even 
preferred  stock  redeemable  at  one  hundred  will  not  bring  more 
than  eighty-five.  How  shall  stock  sold  at  less  than  the  redeemable 
value  be  treated  ?  The  mere  bookkeeping  entries,  assuming  there 
IS  no  question  as  to  the  redeemable  value,  appear  simple  enough, 
since  presumably  the  amount  received  for  the  stock  would  be 
credited  to  a  preferred  capital  account,  with  an  amount  equal  to 
the  difference  between  the  value  received  and  the  redeemable 
value  taken  out  of  surplus,  or  out  of  common  shareholders'  equity, 
and  set  up  as  a  credit  to  preferred  shareholders'  redemption 
account  or  one  bearing  a  similar  descriptive  title. 

The  point  of  difficulty  comes  where  the  rights  of  the  respective 
equities  cross  one  another.  If  the  redeemable  value  is  placed 
upon  the  preferred  stock  with  the  sanction  of  the  common  share- 
holders, there  appears  to  be  no  point  at  issue.  If  the  action  is 
taken  by  the  directors  without  ratification  by  the  common  share- 
holders, there  might  be  grave  danger  not  only  of  conflict  between 
the  two  equities,  but  legal  action  by  the  common  shareholders  for 
the  protection  of  their  equity.  There  is  also  a  counter-question,^ 
in  the  absence  of  ratification,  as  to  what  extent  dividends  may  be 
paid  to  common  shareholders  without  first  providing  the  redemp- 
tion margin  for  the  full  protection  of  preferred  shareholders  out 
of  surplus.  These  points  obviously  should  not  be  overlooked  by 
the  accountant  in  undertaking  to  set  up  the  proper  accounts  or  to 
reflect  through  a  financial  statement  the  relations  between  the 
corporation  and  the  shareholders. 

Another  company,  having  declared  in  advance  a  dividend  on 
preferred  stock  payable  in  quarterly  installments  over  the  ensuing 
year,  presents  a  question  as  to  the  disposition  of  the  dividend 
charge,  in  the  event  that  the  profits  for  the  corresponding  year 
do  not  equal  or  exceed  the  amount  of  the  dividend.  There  being 
in  this  case  no  surplus,  separate  and  distinct  from  the  common 
shareholders'  equity,  it  is  clear  that  any  deficiency  in  profits 
necessary  to  meet  the  charge  for  the  preferred  dividend  could  be 
charged  only  against  the  common  shareholders'  equity.     Again 

301 


Principles  of  Accounting 

there  arises  a  question  as  to  the  right  of  the  directors  to  take 
action  without  their  consent  which  would  reduce  the  equity  of  the 
common  shareholders.  The  conflict  here  is  between  the  directors 
and  the  common  shareholders,  rather  than  between  the  corporation 
and  the  state,  since  the  stated  capital  is  sufficiently  under  the 
combined  preferred  capital  stock  and  common  shareholders' 
equity  so  that  the  statute  governing  the  payment  of  dividends  in 
reduction  of  capital  would  not  be  violated. 

The  problems  surrounding  capital  stock  without  par  value  are 
too  varied  to  permit  of  general  rules  for  their  solution.  It  would 
therefore  be  ill-advised  to  attempt  the  formulation  of  rules  to 
govern  the  accounting  related  thereto.  On  the  other  hand,  it 
may  be  found  helpful  if  a  few  classified  thoughts,  in  summary 
form,  are  set  down,  to  wit : 

1.  Ascertain  the  state  in  which  the  corporation  is  chartered 
and  consult  the  laws  thereof  bearing  on  shares  of  stock  without 
par  value,  particularly  as  to  provisions  of  issue  and  dividends. 

2.  Determine  amount  of  stated  capital,  if  any,  and  take  into 
consideration  the  significance  thereof. 

3.  Credit  amounts  received  or  values  arising  from  sales  or 
issues  of  stock  to  an  account  entitled  "Paid-in  Capital,"  dififer- 
entiating  in  case  there  is  both  preferred  and  common  stock. 

4.  Credit  net  profits  or  charge  net  losses  to  surplus  account. 
The  idea  that  a  corporation  having  stock  without  par  value  has  no 
need  for  a  surplus  account  is  erroneous. 

5.  Credit  appreciation  of  property,  when  based  on  sound 
values,  to  special  surplus  account.  This  suggestion  is  based 
purely  on  the  theory  of  classification  and  a  desire  to  maintain  the 
regular  surplus  account  as  a  summary  of  operating  results  unaf- 
fected by  credits  arising  through  revaluation,  or  other  adjust- 
ments, and  not  because  the  special  surplus  is  legally  different  in 
character  for  dividend  purposes. 

6.  Declare  cash  dividends  out  of  surplus  from  operations  and 
apply  charges  for  such  declarations  against  such  ■  surplus  until 
the  latter  has  been  exhausted.  Dividends,  presumably,  may  be 
declared  out  of  any  surplus,  but  may  not  encroach  upon  stated 
capital.  Paid-in  capital  and  stated  capital  are  not  necessarily 
synonymous,  and  it  is  probable  that  in  cases  where  the  paid-in 
capital  exceeds  the  stated  capital,  the  excess  may  in  some  states 

302 


Capital  Stock  without  Par  Value 

be  used  for  dividends.  In  certain  states,  however,  the  statutes 
are  specific  in  prohibiting  such  use. 

7.  The  wisdom  of  setting  up  a  specific  redemption  account  for 
the  diflference  between  the  paid-in  capital  and  the  redeemable 
values  in  the  case  of  preferred  stock  without  par  value  is  in  ques- 
tion. At  least  a  notation  as  to  the  redeemable  value  should  be 
made  at  the  head  of  both  preferred  and  common  accounts  show- 
ing the  paid-in  values. 

As  to  the  balance  sheet,  there  are  several  moot  questions. 
The  most  notable  one,  probably,  is  that  which  concerns  the  man- 
ner in  which  the  excess  of  assets  over  liabilities  and  preferred 
capital,  if  any,  shall  be  shown.  Other  questions  have  to  do 
with  the  manner  of  showing  the  preferred  shareholders'  equity 
where  there  are  preferred  shares  without  par,  but  with  a  redeem- 
able value. 

The  first  thought  which  usually  arises  in  the  mind  with  regard 
to  the  balance  sheet  is  that  the  excess  of  assets  over  liabilities  and 
preferred  capital,  if  any,  belongs  to  the  common  shareholders 
and  represents  their  equity  in  the  assets.  On  this  ground  it  is 
frequently  contended  that  there  is  no  reason  for  showing  the 
excess  in  question  except  in  one  sum  described  as  common  share- 
holders' equity.  But  objection  to  this  arises  from  the  fact  that 
such  procedure  indicates  in  no  way  the  derivation  of  the  equity 
amount  and  may  obscure  material  information  bearing  on  the 
status  and  administrative  policy  of  the  company,  or  in  fact  con- 
ceal capital  transactions  in  which  the  reader  of  the  balance  sheet 
is  properly  interested. 

Showing  the  equity  in  one  sum  prevents  the  disclosure  of 
(a)  how  much  common  capital  was  paid  in ;  (b)  how  much  repre- 
sents accumulation  of  net  earnings ;  (c)  whether  or  not  there  have 
been  encroachments  on  paid-in  capital  through  dividends  or  losses ; 
(d)  whether  or  not  any  of  the  equity  is  represented  by  apprecia- 
tion of  assets;  (e)  whether  or  not  any  cash  or  stock  dividends 
have  been  declared  or  paid  during  the  period  ended  at  the  date 
of  the  balance  sheet. 

All  of  the  above  information  is  essential  to  proper  considera- 
tion of  the  company's  condition  by  shareholders,  by  bankers,  or 
by  any  other  interested  parties,  and,  if  shown,  tends  to  promote 
confidence  rather  than  excite  suspicion,  even  though  the  showing 
may  not  be  as  favorable  as  might  be  desired. 

303 


Principles  of  Accounting 

As  a  concession  to  the  wishes  of  clients  the  public  accountant 
may  find  it  necessary  to  condense  the  figures  representing  the 
phases  of  common  proprietorship  above  mentioned,  even  to  the 
extent  of  showing  the  common  shareholders'  equity  in  one  amount. 
He  should  hold,  however,  for  the  distinction  on  the  balance  sheet 
between  capital  and  surplus.  If  this  is  not  acceptable,  he  should 
insist  that  the  assets  and  liabilities  as  well  as  the  preferred  capital 
be  so  described  as  to  bring  out  any  important  facts  having  a  bear- 
ing on  the  values  upon  which  the  common  shareholders'  equity 
is  based. 

The  question,  in  the  case  of  preferred  shares,  of  how  the  ex- 
cess of  redeemable  value  over  paid-in  value  should  be  shown  is 
somewhat  perplexing.  To  take  the  excess  out  of  surplus  or  out 
of  common  shareholders'  equity  and  set  it  up  as  a  credit  in  favor 
of  preferred  shareholders,  is  perhaps  somewhat  arbitrary.  Such 
procedure  might  indicate  a  positiveness  with  regard  to  the  legal 
relations  between  the  common  and  the  preferred  shareholders 
not  justified  by  the  facts  nor  within  the  province  of  the  account- 
ant. If,  however,  the  two  groups  of  shareholders  are  agreed 
as  to  the  rights  of  the  preferred  group,  the  legal  obstacle  is 
removed  and  there  remains  the  question  as  to  the  method  which 
will  best  express  the  situation.  On  this,  opinion  may  be  divided. 
There  can  be  no  question  of  definiteness  if  the  amount  involved 
is  set  up  as  a  redemption  reserve.  On  the  other  hand  the  same 
result  would  seem  to  be  accomplished  by  making  use  of  paren- 
thetical descriptions. 

An  explanatory  caption  in  connection  with  the  preferred  stock 
might  answer  the  purpose  as  to  that  stock.  It  might  fail  in  its 
purpose  if  the  reader  of  the  balance  sheet  were  considering  the 
common  stock  and  failed  to  notice  the  qualification  attaching  to 
the  preferred.  It  appears,  therefore,  that  the  procedure  most 
satisfactory  to  all  concerned  will  be  found  in  qualifying  both 
captions,  somewhat  as  follows: 

Preferred  stock  (50,000  shares  without  par  value, 
redeemable  at  $100  each,  and  requiring  in  the  event 
of  redemption  a  payment  of  $750,000  in  addition  to 

the  value  shown  herewith) $4,250,000 

Common  shareholders'  equity  (subject  to  charge  of 
$750,000  for  redemption  of  preferred  stock)  100,000 
shares  without  par  value: 

Paid-in   capital $6,250,000 

Surplus    1,750,000  $8,000,000 

304 


Capital  Stock  without  Par  Value 

It  appears  important  on  account  of  the  variation  in  laws  of 
different  states  that  any  balance  sheet  involving  shares  of  stock 
without  par  value  should  show  the  state  in  which  the  corporation 
was  organized.  It  is  also  important  that  in  any  case  where  the 
laws  of  the  state  make  a  provision  for  stated  capital  the  amount 
thereof  should  be  shown  on  the  balance  sheet. 


305 


INDEX 


Account  Form,  240 

Accounts, 
Accounts  receivable,  21,  84,  236, 
246;  Arrangement  of,  in  books, 
22;  Bad,  232;  Capital,  6;  Classifi- 
cation of,  6,  84,  85 ;  Consumption, 
74,  76;  Contract,  42;  Controlling, 
19,  21;  Cost  of  Sales,  162;  De- 
ficiency, 240,  264,  267;  Doubtful, 
232;  Elimination  of,  251,  252; 
Finished  Goods,  74,  78,  79,  80; 
General,  19,  20,  237;  Goods  in 
Process,  74,  79,  80,  81;  Group,  19; 
Inventory,  78 ;  Manufacturing, 
161,  162;  Materials  and  Supplies, 
74,  75,  79,  80;  Mixed,  74,  75; 
Nominal,  7;  Classified,  14;  Pay- 
able, 246;  Property,  23;  Proprie- 
tor's, 6;  Real,  7;  Realization  and 
Liquidation,  271 ;  Statistical  or 
Administrative,  19,  20;  Summary, 
19,  20;  Taxes  accrued,  226,  227; 
Trading,  257 

Accruals,  234-237 

Administrative  Expense,  Classifica- 
tion of,  174,  259 

Advances,  Elimination  of,  251,  252 

Advertising,  113,  172,  236,  237 

Allowances,  146,  156,  161,  217 

Amortization, 
Meaning     of     Term,     183;     Of 
Patents,    Trademarks    or    Good- 
will, 232;  Of  Premiums,  dl 

Applied  Theory  Test, 
No.  1,  25;  No.  2,  43;  No.  3,  47; 
No.  4,  55,  56,  57 

Architect,  Duties  of,  28 

Assessment,  Definition  of,  224 

Assets, 
And  Liabilities,  8,  9;  Arrange- 
ment of,  242,  246 ;  Illustration  of, 
243 ;  Current,  8,  82,  242 ;  Deferred 
Charges  to  Income,  9,  10;  Fixed 
or  Capital,  9;  Miscellaneous  or 
Special,  9,  236;  Note  as,  85; 
Working  and  Trading,  9,  74 


Bad  Accounts,  232 
Balance  Sheet, 

Arrangement  of  Assets  on,  246; 

Classified,  242;  Consolidated,  250; 


Specimen  of,  255;  Definition  of, 
122,  240;  Discussion  of,  239; 
General,  243;  Schedules  support- 
ing, 244,  245,  249,  250 

Bill,  86;  Of  Exchange,  86 

Bonds,  66 
And  Mortgages,  70,  71;  Value 
of,  71 ;  And  Stocks  and  Assets, 
how  carried,  72;  Definition  of, 
125,  126;  Discounting  of,  127; 
Elimination  of,  251,  252;  Interest 
on,  69,  128 ;  Purchased  below  Par, 
Interest  on,  182,  183;  Method  of 
Keeping  Record  of,  68,  69;  Sold 
at  a  Premium,  128 

Bonuses,  177 

Buildings, 
Alterations  to,  51;  Architect's 
duties  in  connection  with,  28; 
Contracts  for,  28,  29,  30;  Con- 
tractor's position  in  erection 
of,  30;  Contractor's  Reserve,  32, 
2)Zy  42;  Convenience  in  Construc- 
tion of,  45;  Depreciation  of, 
Method  of  Entering,  235;  Dis- 
position of,  53;  Estimates  for, 
31,  32;  Given  as  Security,  46; 
Improvements  to,  49.  50:  Insur- 
ance of,  52;  Methods  of  handling 
contracts  on  books  of  contractor, 
34,  35,  Z(i,  Z7,  38,  39,  40;  Methods 
of  handling  contracts  for,  on 
client's  books,  29;  Renewals  and 
Replacements  of,  50;  Repairs  to, 
50;  Ways  of  Obtaining,  27,  45; 
What  may  Happen  to,  49,  53 


Capital,  179;  Contributors  of,  241; 
Liabilities,  Form  of,  125;  Of 
Value  to  Administrative  Force, 
213 

Capital  Stock,  72,  150;  Elimination 
of,  251 ;  Classification  of,  151; 
Dividends  on,  152;  Increase  in 
Value  of,  153;  Without  Par 
Value,  154,  288 

Cartage,  Outward,  155,  158;  In- 
ward, 159,  160 

Cash,  Adjustment  of,  at  Closing, 
236 ;  Book,  83 ;  Discounts  on  Pur- 
chases,   181 ;    on    Sales,    185 ;    In 


306 


Index 


Hand,  82 ;  Petty,  82 ;  Position  of, 
on  balance  sheet,  246;  Working 
Funds,  82,  83 

Charges,  Deferred,  to  Expense,  109 

Classified  Balance  Sheet,  242 

Closing  Entries,  234,  237 

Closing  of  a  Title,  46,  47 

Commissions,  171,  237 

Consigned  Sales,  123,  124 

Consignments,  Adjustment  of,  237; 
Carried  on  Memorandum  Book, 
121 ;  Charging  of,  to  Agent,  124 ; 
Consignor's  Account,  Procedure 
to  be  followed  in,  119,  120;  Dis- 
position of,  when  taken  up  at 
receipt  of  goods,  116-119;  Dis- 
position of,  when  taken  up  at 
time  of  sale,  121;  Elimination  of, 
251,  252;  From  viewpoint  of  Con- 
signee, 115;  Accounting,  117; 
Books  to  be  kept,  117;  Invoice, 
116;  Goods  Shipped  on  123;  In- 
voiced at  specified  prices,  123; 
On  Memorandum,  123;  Goods 
received  on,  115;  Manner  of 
handling,  on  balance  sheets,  248; 
Manner  of  showing  account  on 
balance  sheet,  122 

Consolidated  Balance  Sheet,  250; 
Specimen  of,  255 

Consumption  Account,  74,  76 

Contracts  for  Buildings,  28 

Contributors  of  Capital,  Classifica- 
tion of,  241 

Copartnerships,  Insurance  of  em- 
ployes of,  216;  Interest  important 
factor  in,  212,  213 

Copyrights,  90;  Value  of,  91,  93,  94 

Corporations,  Insurance  of  em- 
ployes of,  216 

Cost,  Manufacturing,  159;  Of 
Sales,  159,  162,  163;  Prime,  159 

Creditors,  241 

Current  Assets,  82;  Accounts  Re- 
ceivable, 82;  Adjustment  of,  at 
closing,  236;  Cash,  82;  Notes  re- 
ceivable, 82 

Current  Liabilities,  246 


Debenture,  126 

Debtors,  241 

Deductions  from  Income,  185 

Deficiency  Account,  240.  264,  267 

Deferred  Charges  to  Expense, 

Methods  of  Handhng,   109,  110; 

Nature  of,  109 
Depreciation,    Definition    of,    190; 

Duration     of     asset     important 

factor    in    calculation    of,    200; 

Examples     of,     191,     192,     193; 


Methods  of  calculating,  196,  197; 
Chart  showing,  199;  Necessity  of 
providing  for,  194 ;  Of  Land,  195 ; 
Rates  of.  Variance  in,  194,  195; 
Relation  of,  to  repairs,  196; 
Treatment  of,  in  accounts,  201 

Development  Expense,  113,  114 

Directors'  Fees,  175 

Discount,  Cash,  181 ;  Classification 
of,  208;  Distinction  between  in- 
terest and,  209;  Register,  211; 
Treatment  of,  in  accounts,  209, 
210;  Unearned,  210;  Treatment 
of,  by  banks,  211 

Dividends,  19,  180,  181;  Payable, 
137,  233 

Donations,  177 

Doubtful  Accounts,  232 

Elimination  of  Accounts,  251,  252 

Employers'  Liability  Insurance,  223 

Equipment, 
Accounts  for,  63,  64;  Building, 
59;  Cost  of,  62;  Disposition  of, 
62 ;  How  acquired,  62 ;  Machinery 
and  tools,  divisions  of,  62,  63; 
Meaning  of  term,  58;  Technical, 
59;  Classification  of,  60;  What 
may  Happen  to,  62 

Expense,  Administrative,  174;  De- 
finition of,  15;  General,  177; 
Legal,  176;  Miscellaneous,  174, 
176,  177;  Office,  170;  Operating, 
15,  16;  Of  Salesmen,  170;  Sales 
Department,  170;  Traveling,   176 

Financial  Condition,  6 

Financial  Statements,  Classification 
of,  239,  240;  Preparation  of,  239; 
As  Aids  to  Administration,  274 

Fire  Insurance,  216;  Treatment  of, 
22 

Franchise,  Duration  of,  97;  Pur- 
poses for  which  granted,  95; 
Valuation  of,  96 

Freight,  Inward,  159,  160;  Out- 
ward, 155,  157 

Funds,  as  Assets,  103;  Classifica- 
tion of,  103;  Creation  of,  104; 
Deposit  of,  105,  106;  Interest  on, 
105,  107;  Methods  of  Handling, 
141,  142^  143,  144,  145,  146;  Re- 
lation of  to  Reserves,  140;  Sink- 
ing, 105;  Object  of,  141 

General  Balance  Sheet,  243 ;  Sched- 
ules supporting,  244,  245 

General  Expenses,  177 

Goods,  Finished,  74,  79,  80,  81,  235 ; 
In  Process,  74,  79,  80,  81,  235,  236 


307 


Index 


Goodwill,  Adjustment  of,  236;  Allo- 
cation of,  246;  Amortization  of, 
232 ;  Different  kinds  of,  102 ;  Dis- 
position of,  102;  Duration  of, 
101;  Meaning  of  word,  98; 
Methods  of  Valuation  of,  99, 
100 

Government,  as  Party  at  Interest 
•in  an  organization,  241;  Finan- 
cial statement  demanded  by,  242 

Gratuities  to  Employes,  177 

Gross  Profit,  Method  of  Obtaining, 
165;  On  Cost,  165,  166;  On  Sales, 
165,  166;  Percentage  of,  167 


Health  Insurance,  216 

Holding  Companies  or  Trusts,  Sub- 
sidiaries of,  250,  251;  Elimination 
of  accounts  of,  251,  252,  253 

Improvements  to  Property,  50 

Income,  and  Profit  and  Loss,  State- 
ment of,  158,  163,  173,  178,  184, 
189,  239,  240,  257,  261;  Consoli- 
dated Statement,  250,  251 ;  Speci- 
men sheet  for,  255;  Bonds,  126; 
Deductions  from,  185,  259,  260; 
Distinction  between,  and  Profits, 
230;  From  Operations,  14,  179, 
185,  259;  From  Sales,  155,  258; 
Gross,  259;  Net,  259;  Secondary, 
or  Primary,  179,  259;  Sources 
of,  15 

Insurance,  Adjustment  of,  236; 
Classification  of,  215 ;  Companies, 
Commissions  paid  by,  171 ;  Credit, 
222;  Definition  of,  215;  Deprecia- 
tion in  relation  to,  221 ;  Employ- 
ers' Liability,  223 ;  Expense,  185, 
187;  Fire,  216;  Health,  215;  Life, 
215;  Politics,  Cancellation  of, 
111 ;  Relations  of  Parties  to,  219- 
221;  Premiums,  216,  217,  223; 
Register,  110,  218;  Unexpired, 
Computation  of,  217-219;  Valua- 
tion of,  111 

Interest,  Accrual  of,  206,  207,  211; 
As  Item  of  Expense,  206;  As 
Item  of  Income,  206;  Character- 
istics of,  205 ;  Definition  of,  205 ; 
Distinction  between  Discount  and, 
209;  Elimination  of,  251,  252; 
Entries  in  connection  with,  207, 
208 ;  Methods  of  Computing,  205 ; 
Example  of,  206;  On  Accounts 
Payable,  185 ;  On  Bonds,  180,  and 
Mortgages  Payable,  185;  On 
Capital,  185 ;  On  Notes  and  Loans 
Payable,  185;  On  Taxes,  227; 
When  to  Charge  and  Credit,  213, 
214 


Inventory,  Account,  78;  Adjust- 
ment of,  237 ;  Method,  75,  79,  161 ; 
Of  Materials  and  Supplies,   162 

Investments,  Bonds,  66;  Bonds  and 
Mortgages,  70;  Classification  of, 
248;  Fluctuation  of,  Method  of 
Entering,  235 ;  Purpose  of,  65 ; 
Stocks,  69;  Treasury  Stock,  72, 
73 

Inward  Cartage,   159,   160,  162 

Inward  Freight,  159,  160,  162 

Labor,  Direct  and  Indirect,  159 

Land,  Account  for.  Acquisition 
of,  24;  As  factor  in  Production 
of  Income,  25;  Disposition  of, 
25;  Increase  in  value  of,  Method 
of  Entering,  234;  What  may 
Happen  to,  25 

Legal  expenses,  174,  176 

Liabilities,  Adjustment  of  entries 
on,  237;  Arrangement  of,  242 
Illustration  of,  243;  Capital,  10, 
125;  Current,  10,  11,  242,  246. 
Deferred  Credits  to  Income,  10, 
11;  Secured  and  Unsecured,  126 
Special,  10,  11 

Liability,  8 

License,  95 

Life  Insurance,  215 

Losses,  15;  and  Profit  and  Income, 
Statement  of,  158,  163,  173,  178, 
184,  189,  239,  240,  257,  261 ;  Con- 
solidated Statement,  250,  251; 
Specimen  sheet  for,  255 

Losses,  and  Profits,  16;  Miscel- 
laneous, 231,  232,  233 


Manufacturing,  Cost,  159,  161 ;  De- 
partment, 59;   Overhead,   159 

Materials  and  Supplies,  Account, 
74,  75,  159,  235 ;  Inventory  of,  162 

Members,  as  Contributors 'of  Cap- 
ital, 241 

Miscellaneous  Expenses,   176,   177 

Mixed  Account,  74,  75 

Mortgages,  46 

Moving  Expense,  114 

Nominal  Accounts,  Adjustment  of, 
237;  Analysis  of,  17,  18,  19;  Clas- 
sified, 15,  17;  Definition  of,  7 
Non-par  Value  Stock,  288 
Note,  As  an  Asset,  85;  Considera- 
tion for  indorsing,  182;  Effect  of 
a,  246;  Ehmination  of,  251,  252; 
Interest  on,  86;  Payable,  246; 
Receivable,  87;  Discounting  of, 
88,  249;  Interest  on,  89,  236 


308 


Index 


OfBce  Expense,  170 

Organization,    Expense,    113,    114; 

Parties  at  Interest  in  an,  241 
Outward  Cartage,  155,  158 
Outward  Freight,  155,  157 
Ownership,  149 


Parties  at  Interest  in  Organization, 
241 

Patents,  Amortization  of,  232;  De- 
finition of,  90;  Value  of,  91-93 

Plant  Equipment,  Chart  of  Classi- 
fication of,  61 

Postage,  174,  175,  236 

Premiums  on  Insurance  Policies, 
217,  218,  223 

Primary,  or  Secondary,  Income, 
179 

Prime  Cost,  159 

Principal,  205 

Printing,  174,  175.  236 

Profit,  and  Loss,  14,  259,  261 ;  And 
Income,  Statement  of,  158,  163, 
173,  178,  184,  189,  239,  240,  257, 
261 ;  Consolidated  Statement,  250, 
251 ;  Specimen  sheet  for,  255 ; 
Classification  of,  259;  Gross,  165, 
259;  Selling,  259 

Profits,  and  Losses,  16,  230;  Method 
of  Accounting,  231,  260;  Distinc- 
tion between,  and  Income,  230; 
Meaning  of  word,  140;  Methods 
of  Handling,  141,  147;  Miscel- 
laneous, 230;  Net,  100 

Proprietor,  Account  of,  149;  As 
Contributor  of  Capital,  241 

Proprietorship,  6,  11,  12,  149 

Purchases,  Adjustment  of,  237; 
Classes  of,  161 

Purchasing  Department,  160 


Ratios 
Debt  to  Worth,  280;  Receivables 
to  Merchandise,  286;  Worth  to 
Fixed  Assets,  286;  Sales  to  Re- 
ceivables, 286;  Sales  to  Mierchan- 
dise,  286;  Sales  to  Worth.  286; 
Sales  to  Fixed  Assets,  286 

Real  Accounts,  7 

Rebates,  155,  157,  161 

Register,  Discount,  211 ;  Insurance, 
218 

Rent,  46,  47,  70,  112,  180,  185,  186, 
187 

Report,  Form  of.  240 

Reserves,  Considered  as  Capital,  11, 
138;  Creation  of,  135,  for  de- 
preciation, 203 ;  Disposition  of, 
136,  137 ;  Duration  of,  137 ;  Fund- 


ing the,  202;  Location  of,  on 
balance  sheet,  138;  Methods  of 
Handling,  141-147;  Purposes  of, 
103,  130,  131,  135,  136;  Relation 
of  Funds  to,  140;  Treatment  of, 
246,  247;  Use  of  word,  132; 
Various  kinds  of,  133,  134 


Salaries  of  Officers  and  Clerks,  175 

Sales,  Adjustment  of,  at  closing, 
237;  Cost  of,  159,  161;  Deduc- 
tions, 158;  Elimination  of,  251, 
252;  Gross,  155;  Gross  Profit  on, 
165;  Income  from,  155,  158;  Re- 
turn. 155 ;  Turnover,  168 

Salesmen,  Adjustment  of  Accounts 
of,  236;  Commissions  of,  171; 
Expenses  of,  170 

Schedules  supporting  balance  sheet, 
249,  250 

Secondary  Income,  179 

Securities,  Classification  of,  248 

Selling,  Expense,  172;  Account, 
173;  Price,  156 

Sinking  Funds,  Adjustment  of,  236; 
Creation  of,  105;  Treatment  of, 
247 

Statement,  Of  Affairs,  Definition 
of,  240,  264;  Preparation  of,  265; 
Specimen,  266 ;  Of  Cash  Receipts, 
Definition  of,  240;  Preparation 
of.  Specimen  of,  270;  Of  Income 
and  Profit  and  Loss,  158,  163, 
173,  184.  222,  239,  240,  257,  261 ; 
Consolidated  250,  251 ;  Specimen 
sheet  for,  255,  256;  Of  Realiza- 
tion and  Liquidation,  Definition 
of,  240,  Preparation  of,  267, 
Specimen,  268,  269 

Statements,  Financial,  Preparation 
of,  239;  Statistical,  239 

Stationery,  174,  175,  236 

Stock,  Certificates,  Issuance  of,  150, 
151;  Definition  of  word,  69,  70; 
Donated,  Treatment  of,  153,  154; 
Issuance  of  151 ;  Records,  76 

Stockholders,  as  Contributors  of 
Capital,  241 

Subsidiaries,  250,  252;  Elimination 
of  accounts  of,  251,  252,  253 

Surplus,  137 


Taxation  of  Corporations,  224 
Taxes,  112,  185,  246;  Accrual  of, 
226,  228 ;  Bill,  Treatment  of,  227 ; 
Classification  of,  224;  Interest 
on,  226,  227;  Method  of  Com- 
puting, 224,  225;  Prepaid,  Treat- 
ment of,  226 


309 


Index 

Taxpayers      as      Contributors     of  Trademarks,  90;   Amortization 

Capital,  241  232;  Value  of,  91,  92,  93 

Telegraph,  174,  175,  176  I^^^^"^  Account,  257 

Telephone,  174,  175,  176  traveling  Expenses,  174    176 

Time,  as  characteristic  of  interest,  ^^irnoVe";,  16^169   ^^'  ^^^ 

Title,  Closing  of  a,  46,  47  Wages,  246 

Trade  Discount,   155,   156,   161  Working  Fund,  82,  83 


310 


THIS  J^ooir 


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UNIVERSITY  OF  CAUFORNIA  LIBRARY 


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